International Finance Problems

Chapter 1: Valuation Model for an MNC

Domestic Model

  E  CF$,t   
n
V   t 
t 1  1  k  

Where

 V represents present value of expected cash flows

 E(CF$,t) represents expected cash flows to be received at the end of period t,
 n represents the number of periods into the future in which cash flows are received, and
 k represents the required rate of return by investors.

Multinational Model

E  CF$,t    E  CF j ,t   E  S j ,t  
m

j 1
Where

CFj,t represents the amount of cash flow denominated in a particular foreign currency j at the end of
period t,

Sj,t represents the exchange rate at which the foreign currency (measured in dollars per unit of the
foreign currency) can be converted to dollars at the end of period t.

Derive an expected dollar cash flow value for each currency

Combine the cash flows among currencies within a given period

Ex: Carolina Co has expected cash flows of $100,000 from local business and 1 million Mexican Pesos
from business in Mexico at the end of period t. Assuming that the peso’s value is expected to be $0.09
when converted into dollars, the expected dollar cash flows are:

= $CF from US operations + $CF from operations in Mexico

=100,000 + [1,000,000 pesos x $0.09]

=100,000 + 90,000

=$190,000

The cash flow of $100,000 from US were already denominated in US dollars and therefore didn’t have to
be converted.

Chapter 3: Foreign Exchange Quotations

Bidding

Computation of the Bid Ask Spread

Direct and Indirect Exchange Rate Quotations

Indirect quotation = 1 / Direct quotation

Cross Exchange Rates

Value of peso = $0.07, Value of Canadian dollar = $0.70

Value of peso in C$ = Value of peso in $/Value of C$ in $

= $0.07/$0.70 = C$ 0.10

Chapter 4: Exchange Rate Determination

Domestic Model
S  S t 1
Percent  in foreign currency value 
St 1
A positive percent change indicates that the currency has appreciated.

A negative percent change indicates that it has depreciated.

Factors That Influence Exchange Rates

The equilibrium exchange rate will change over time as supply and demand schedules change.

e  f ( INF , INT , INC , GC, EXP)

where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between the U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
Fisher Effect:

Real interest rate  Nominal interest rate  Inflation rate

Depreciation
Value of currency x (1 - depreciation)

Ex: The value of euro was $1.30 last week. During last week the euro depreciated by 5%. What is the
value of euro today?

$1.3  (1  .05) = $1.235

Chapter 5: Currency Derivatives

Premium or Discount on the Forward Rate
F = S(1 + p)

F is the forward rate

S is the spot rate

p is the forward premium, or the percentage by which the forward rate exceeds the spot rate.
Closing Out a Futures Contract

Source of Gains from Buying Currency Futures

Factors Affecting Currency Call Option Premiums

The premium on a call option (C) is affected by three factors:

Spot price relative to the strike price (S – X): The higher the spot rate relative to the strike price, the
higher the option price will be.

Length of time before expiration (T): The longer the time to expiration, the higher the option price will
be.
Potential variability of currency (σ): The greater the variability of the currency, the higher the probability
that the spot rate can rise above the strike price.

Factors Affecting Put Option Premiums

Put option premiums are affected by three factors:

Spot rate relative to the strike price (S–X): The lower the spot rate relative to the strike price, the higher
the probability that the option will be exercised.

Length of time until expiration (T): The longer the time to expiration, the greater the put option
premium

Variability of the currency (σ): The greater the variability, the greater the probability that the option may
be exercised.

Ex: Assume that a speculator purchases a put option on British pounds (with a strike price of $1.50) for
$.05 per unit. A pound option represents 31,250 units. Assume that at the time of the purchase, the spot
rate of the pound is $1.51 and continually rises to $1.62 by the expiration date. What’s the highest net
profit possible for the speculator based on the information above?

SOLUTION: The premium of the option is $.05  (31,250 units) = $1,562.50.

Since the option will not be exercised, the net profit is $1,562.50.

Chapter 6: Exchange Rate Behavior

Indirect Intervention
The Fed can affect the dollar’s value indirectly by influencing the factors that determine it.
 e  f (INF , INT , INC , GC, EXP)

where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between the U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
Chapter 7: International Arbitrage And Interest Rate Parity
Triangular Arbitrage
Money exchange: Amount of currency/currency per other currency

Ex: Exchange dollars to pounds where money needed to change is 10,000 and it’s $1.60 per pound

10000/1.60=6250

Interest Rate Parity

1  ih
p 1
1 if
where
p  forward premium
ih  home interest rate
i f  foreign interest rate
Determining the Forward Premium
 F S
p  ih  i f
S
where
p  forward premium (or discount)
F  forward rate in dollars
S  spot rate in dollars
ih  home interest rate
i f  foreign interest rate