Introduction

to global
finance
 Introduction
Today’s MNEs depend not only on the
emerging markets for cheaper labor, raw
materials, and outsourced manufacturing, but
also increasingly on those same emerging
markets for sales and profits
 “
○ BRIC (Brazil, Russia, India, and China)
○ BIITS (Brazil, India, Indonesia, Turkey,
South Africa, which are also termed the
Fragile Five)
○ MINT (Mexico, Indonesia, Nigeria, Turkey)
 The Global Financial Marketplace
○ Business—domestic, international, global—
involves the interaction of individuals and
individual organizations for the exchange of
products, services, and capital through
markets.
○ The global capital markets are critical for the
conduct of this exchange.
 Assets, Institutions, and Linkages
○ Assets
○ Financial assets at the heart of the global
capital markets are the debt securities issued
by governments
○ The health and security of the global financial
system relies on the quality of these assets.
 Assets, Institutions, and
Linkages
○ Institutions
○ Central banks, commercial banks, other
financial institutions
○ The health and security of the global financial
system relies on the stability of these financial
institutions
 Assets, Institutions, and
Linkages
○ Linkages

○ The links between the financial institutions,

the actual fluid or medium for exchange,
are the interbank networks using currency.
Global Capital Markets
 The Market for Currencies
Foreign currency exchange rate

○The price of any one country’s

currency in terms of another
country’s currency
○E.g. PHP53.2345/USD
 The Market for Currencies

○Eurocurrencies are domestic

currencies of one country on
deposit in a second country for a
period ranging from overnight to
more than a year or longer.
 Two valuable purposes
of eurocurrencies
○Eurocurrency deposits are an
efficient and convenient
money market device for
holding excess corporate
liquidity
 Two valuable purposes
of eurocurrencies
○ the eurocurrency market is a
major source of short-term
bank loans to finance
corporate working capital
needs, including the financing
of imports and exports
 Eurocurrency interest
rates
London Interbank Offered Rate
(LIBOR)
the most widely accepted rate of
interest used in standardized
quotations, loan agreements or
financial derivatives valuations
 Theory of Comparative
Advantage
Absolute advantage –every country
specializing in the production of those
goods for which it was uniquely suited
 Theory of Comparative
Advantage
Absolute advantage –the ability to
produce a good using fewer inputs than
another producer
 Theory of Comparative
Advantage
Comparative advantage –the
ability to produce a good at a lower
opportunity cost than another
producer
Production possibilities for the United States and Mexico
Opportunity-Cost Ratio in the United States
United States: 1V ≡1B

Opportunity-Cost Ratio in Mexico

Mexico: 2V ≡ 1B

Terms of Trade: 1.5V ≡ 1B

What is Different about international
Financial Management?
What is Different about international
Financial Management?
 Why Do Firms become
Multinational?
○Market seekers
○Raw material seekers
○Production efficiency seekers
○Knowledge seekers
○Political safety seekers
 The
Globalization
Process
 ○Global Transition I:
This is a slide
title

○A firm moves from the

domestic phase to the
international trade phase
 ○Global transition II: the
This is a slide
international trade
title phase to the
multinational phase:
○A firm moves from the
domestic phase to the
international trade phase
The Limits to Financial
Globalization
Globalization and the
Multinational Firm
International finance vs domestic finance

Dimensions that differentiate international

finance with domestic finance

1. Foreign exchange and political risks

2.Market imperfections
3.Expanded opportunity set
Goals for International Financial
Management

1. Shareholder wealth maximization

2.Other goals
Agency problem (Principal-agent problem)
Corporate governance
Major trends in globalization

1. Emergence of Globalized Financial Markets

2. Emergence of the Euro as a Global Currency
3. Debt crisis
4. Trade Liberalization and Economic Integration
5. Privatization
6. Global Financial Crisis of 2008–2009
Multinational Corporations

a business firm incorporated in one

country that has production and sales
operations in many other countries
MNC: Enhancing Its Global Presence

(i) spreading R&D expenditures and advertising

costs over their global sales
(ii) pooling global purchasing power over
suppliers
(iii) utilizing their technological and managerial
know-how globally with minimum additional
costs, and so forth
International
Monetary
System
ELECT04
Evolution of the International Monetary
System
❑ Bimetallism: Before 1875
❑ Classical gold standard: 1875–1914
❑ Interwar period: 1915–1944
❑ Bretton Woods system: 1945–1972
❑ Flexible exchange rate regime: Since
1973.
Bimetallism: Before 1875

❑ gold and silver were used as

international means of payment

❑ exchange rates among currencies were

determined by either their gold or
silver content
Bimetallism: Before 1875

❑ Gresham’s law
❑ “bad” (abundant) money drives out
“good” (scarce) money
Classical Gold Standard: 1875–1914
international gold standard
1. gold alone is assured of unrestricted
coinage
2. there is two-way convertibility
between gold and national currencies
at a stable ratio
3. gold may be freely exported or
imported
Classical Gold Standard: 1875–1914
• The exchange rate between any two
currencies will be determined by their
gold content

• Example:
• Price of gold (Britain) = GBP6.00/ounce
• Price of gold (France) = FRF12.00/ounce
• Exchange rate: 12/ 6 = FRF2.00/GBP
Classical Gold Standard: 1875–1914
• Price-specie-flow mechanism
• Automatic correction of trade imbalances
through price
• Price-specie-flow mechanism
Net Exports
Britain > France

More outflow of gold from

More inflow of gold to Britain
France

Money stock declines, price

Money stock rises, price rises
declines
Classical Gold Standard: 1875–1914
• Shortcomings

• Supply of newly minted gold restricted

trade and investment
• Governments can abandon the gold
standard
Interwar Period: 1915–1944
Characteristics

• Economic nationalism
• Halfhearted attempts and failure to
restore the gold standard
• Economic and political instabilities
• Bank failures
Interwar Period: 1915–1944
Characteristics, cont.

• Flights of capital across borders

• US dollar emerged as the dominant
world currency (replaced the British
pound)
• No coherent IMS
Bretton Woods System: 1945–1972

• Established IMF
• IMF generated set of rules and
international monetary policies and a
mechanism for enforcement
• Established IBRD (World Bank)
• A dollar-based gold-exchange standard
Bretton Woods System: 1945–1972

• Triffin paradox
• SDR
 SDR
Currency Unit Currency amount Exchange rate U.S. dollar equivalent
Chinese yuan 1.01740 6.47950 0.15702
Euro 0.38671 1.21055 0.46813
Japanese yen 11.90000 106.32500 0.11192
U.K. pound 0.08595 1.39250 0.11968
U.S. dollar 0.58252 1.00000 0.58252
USD per SDR 1.43927
USD1.00 = 0.694797
* RMB and JPY currency per USD
the rest are in terms of USD per unit of the currency
The Flexible Exchange Rate Regime: 1973–
Present
Jamaica Agreement
• Flexible exchange rates were declared
acceptable to the IMF members
• Gold was officially abandoned as
international reserve
• Greater access to IMF fund were given to
non-oil and less-developed countries
The Balance of
Payments
The Balance of Payments

▪ The measurement of all

international economic
transactions between the
residents of a country and
foreign residents
Importance of BOP
• indicator of pressure on a country’s
foreign exchange rate
• may signal the imposition or removal of
controls over payment of dividends and
interest, license fees, royalty fees, or
other cash disbursements to foreign firms
or investors
• helps to forecast a country’s market
potential
Measuring international economic
activity
1. Identifying international economic transactions
2. Understanding how the flow of goods, services,
assets, and money create debits and credits to
the overall BOP
3. Understanding the bookkeeping procedures for
BOP accounting
The BOP as a Flow Statement

▪Two types of business transactions

dominate the balance of payments:
▫1. Exchange of Real Assets
▫2. Exchange of Financial Assets
 Generic BOP
A. Current Account
1. Net exports/imports of goods (Balance of Trade)
2. Net exports/imports of services
3. Net income (investment income from direct
portfolio investment + employee compensation
4. Net transfers (sum sent home by migrants and
permanent workers abroad, gifts, grants, and
pensions)
 Generic BOP

B. Capital Account
Capital transfers related to the purchase and sale of
fixed assets such as real estate
 Generic BOP

C. Financial Account
1. Net foreign direct investment
2. Net portfolio investment
3. Other financial items
Financial Account and Components
 Generic BOP

D. Net errors and Omissions

Missing data such as illegal transfers
 Generic BOP

E. Reserves and Related Items

Changes in the official monetary reserves including
gold, foreign exchange and IMF position
The Current Account

A. Current Account
1. Goods trade and import of good
2. Services trade
3. Income
4. Current transfers

4-14
The Capital/Financial Account
▪ Capital account
▪ Financial account
▫ A. Direct investment
▫ B. Portfolio investment
▫ Other investment assets/liabilities

4-15
Net Errors & Omissions/Official
Reserves Accounts

▪Net Errors and Omissions

▪Official Reserves Account

4-16
The BOP in Total — Surplus
▪A surplus in the BOP implies that the
demand for the country’s currency
exceeded the supply

4-17
The BOP in Total — Deficit
▪A deficit in the BOP implies an
excess supply of the country’s
currency on world markets

4-18
The BOP Interaction with Key
Macroeconomic Variables

1. Gross Domestic Product (GDP)

2. The exchange rate
3. Interest rates
4. Inflation rates

4-19
The BOP and GDP
▪A nation’s GDP can be represented by
the following equation:

GDP = C + I + G + X – M

4-20
The BOP and Exchange Rates
▪A country’s BOP can have a significant
impact on the level of its exchange rate and
vice versa
▪The relationship between the BOP and
exchange rates can be illustrated by use of a
simplified equation that summarizes BOP
Data (see next slide)
4-21
‘t repos
BOP and Exchange Rate Regimes/ Systems
Fixed Exchange Rate Countries
▪ If the sum of capital and current account is
>0, there’s a surplus demand for the
domestic currency
▪ Gov’t must sell domestic currencies for
foreign currencies

4-23
BOP and Exchange Rate Regimes/ Systems
Fixed Exchange Rate Countries
▪ If the sum is ─ , excess supply of domestic
currencies exists
▪ Gov’t must buy the excess supply of its
currency in the world market by using its
forex reserves

4-24
BOP and Exchange Rate Regimes/ Systems
Floating Exchange Rate Countries

An excess supply of the domestic currency

will appear on world markets. Like all
goods in excess supply, the market will rid
itself of the imbalance by lowering the price
4-25
BOP and Exchange Rate Regimes/ Systems
Managed Floats
• It is necessary to take action to maintain
desired exchange rate values
• Raise domestic interest rates to attract
additional capital from abroad

4-26
The BOP and Interest Rates
▪ Relatively low real interest rates should
normally stimulate an outflow of capital
seeking higher rates elsewhere

▪ Affects the financial account

4-27
BOP and Inflation Rates
▪ Imports have the potential to lower a
country’s inflation rate

▪ May impact domestic production,

employment

4-28
Trade Balances and Exchange Rates
▪ transmission mechanism
▪ changes in exchange rates change relative
process of imports and exports, and
changing prices in turn result in changes in
quantities demanded through the price
elasticity of demand
4-29
Trade Balance Adjustment to Exchange Rate Changes: The J-
Curve

4-30
The J-Curve Adjustment Path

1) The currency contract period.

sudden unexpected devaluation of the domestic

currency has a somewhat uncertain impact

4-31
The J-Curve Adjustment Path

2) The pass-through period.

As exchange rates change, importers and

exporters eventually must pass these
exchange rate changes through to their own
product prices

4-32
The J-Curve Adjustment Path

3) The quantity adjustment period.

Consumers both in import/export markets adjust

their demands to the new prices.

Imports are relatively more expensive

Exports are relatively cheaper
4-33
Trade Balance Adjustment Path: The Equation
Trade Balance example
▪Exports of US: Qx =12,560, Px = $12.45
▪Imports of US: QM = 13,675, PM = €11.96
▪Spot exchange rate: $1.20182/€
▪Find the US trade balance.
▪Suppose the US dollar has devalued and that the
exchange rate now is $1.23056/€. What happened to
US Trade balance? Assume the same prices and
quantities for export and import.
Capital Mobility

▪The degree to which capital moves freely

across borders

4-36
Capital Mobility

4-37
Exhibit 4.9 A Stylized View of Capital Mobility in
Modern History

4-38
Capital Flight

Although no single definition of capital

flight exists, it has been characterized as
occurring when capital transfers by
residents conflict with political objectives.

4-39
Mechanisms to move capital
1. Transfers via the international payments
mechanism
2. Transfer of physical currency by bearer
3. Cash is transferred into collectibles of precious
metals
4. Money laundering
5. False invoicing of international trade transactions
4-40
Mini-Case Questions: Turkey’s Kriz (A)

▪Where in the current account would the imported

telecommunications equipment be listed? Would
this location correspond to the increase in
magnitude and timing of the financial account?
▪Why do you think that net direct investment
declined from $573 million in 1998 to $112 million in
2000?
▪Why do you think that TelSim defaulted on its
payments for equipment imports from Nokia and
Motorola? 4-41
The Market for
Foreign
Exchange
ELE04 –GLOBAL FINANCE

Created using
Outline
Exchange-
Function and The Traded
Structure of The Spot Forward
the FX Currency
Market market Funds
Market

01 02 03 04
INTRODUCTION

● Forex market is the largest financial market in

the world
● Open somewhere 365 days a year, 24 hours a
day
● Daily trading hit a high of $6.6 trillion in 2020,
a 40% increase from the last decade
(https://asianbankingandfinance.net/)
INTRODUCTION

● The global Forex trading market is worth

$2,409,000,000,000 (that is $2.4 quadrillion)
● (https://asianbankingandfinance.net/)
INTRODUCTION

● 10 most traded
currencies in 2020
(https://www.ig.com/)
Function and Structure
of the FX Market
Structure of FX Market

• An offshoot of the primary functions of a

KB: to assist clients in the conduct of
international commerce
Structure of FX Market

• FX market -worldwide linkage of bank

currency traders, nonbank dealers, and FX
brokers, who assist in trades, connected to
one another via a network of telephones,
computer terminals, and automated
dealing systems
FX Market Participants
FX market as two-tier market

1. wholesale or interbank market

2. retail or client market
 FX market participants

International Bank Nonbank

banks customers dealers

FX brokers Central
banks
 The Spot Market

The spot market involves almost the

immediate purchase or sale of foreign
exchange
Spot Rate Quotation
It can be stated in direct quotations or indirect quotations

Indirect

Direct
Foreign Exchange rates and Quotations

Exchange rate Quotes

CUR1 / CUR2

e.g. USD 1.2174 = EUR 1.00

PHP48.62 = USD1.00
Bid, Ask, and Midpoint Quotation
Cross rates
intermarket arbitrage

This is different from Dresdner Bank’s EUR1.1722/GBP

Triangular Arbitrage by a Market Trader
Sample Problem
The following exchange rates are available to you. (You can
buy or sell at the stated rates.) Assume you have an initial
SF12,000,000. Can you make a profit via triangular
arbitrage? If so, show the steps and calculate the amount
of profit in Swiss francs.
 The Forward Market
Forward quotes

In American terms, the euro is trading at a premium to the dollar; in

European terms, the US dollar is trading at a discount to the euro.
 The Forward Market
Forward Point Quotations
Assume the Swiss franc/U.S. dollar (SF/$) bid-ask rates are SF0.9776–
SF0.9779. With reference to these rates, forward prices might be
displayed as:

If this is smaller
than the first
number, it must
be subtracted
from the spot
 The Forward Market
Forward Point Quotations

NOTE: A point (1 point) is equivalent to 0.0001. Thus, 12 points must be

0.0012.
Calculating outright forward when quotes are in points or
pips

─ ─
Forward Quotations in percentage Terms
Forward premium: Foreign Currency Terms
Forward Quotations in percentage Terms
Forward premium: Home Currency Terms
Premium or Discount on the Forward Rate
The difference between the forward rate (F) and the
spot rate (S) at any given time is measured by the
premium:
 Premium or Discount on the Forward Rate

Example: If the euro’s spot rate is $1.40 and if its one-

year forward rate has a forward premium of 2 percent,
then the one-year forward rate is calculated as follows:
Premium or Discount on the Forward Rate

Given quotations for the spot rate and the forward rate at
any point in time, the premium can be determined by
rearranging the previous equation:
Premium or Discount on the Forward Rate

If the euro’s one-year forward rate is quoted at $1.428

and the euro’s spot rate is quoted at $1.40, then the
euro’s forward premium is:
Premium or Discount on the Forward Rate

If the euro’s one-year forward rate is quoted at $1.35 and

the euro’s spot rate is quoted at $1.40, then the euro’s
forward premium is:
Exchange-Traded Currency Funds

• a portfolio of financial assets in which shares

representing fractional ownership of the fund trade on
an organized exchange
• ETFs allow small investors the opportunity to invest in
portfolios of financial assets that they would find
difficult to construct individually
Exchange-Traded Currency Funds

• Guggenheim Investments first offered an ETF on the

euro common currency named the Currency Shares
Euro Trust.
• The fund is designed for both institutional and retail
investors who desire to take a position in a financial
asset that will track the performance of the euro with
respect to the U.S. dollar
Exchange-Traded Currency Funds

• Guggenheim issues baskets of 50,000 shares for

• trading, with each share representing 100 euros.
Individual shares are denominated in the U.S. dollar
and trade on the New York Stock Exchange. The net
asset value (NAV) of one share at any point in time will
reflect the spot dollar value of 100 euros plus
accumulated interest minus expenses.
International Parity
Relationships and
Forecasting Foreign
Exchange Rates
Created using

Ele04 –global finance

01 02
Interest Rate Purchasing Power
Parity Parity

03 04
Forecasting
Fisher Effects
Exchange Rates
 INTRODUCTION

The economic theories

that link exchange
rates, price levels, and
interest rates are called
international parity
conditions
 Interest Rate Parity

• an arbitrage condition that must

hold when international financial
markets are in equilibrium
 Interest Rate Parity

• Investing domestically at the

prevailing interest rate:
• $1(1 + i$)
• No uncertainty and default-free
 Interest Rate Parity

• Invest abroad (UK):

1. Exchange $1 for a pound amount,
that is, £(1/S ), at the spot rate, S.
2. Invest the pound amount at the
U.K. interest rate, i£
 Interest Rate Parity

3. Sell the maturity value of the U.K.

investment forward in exchange
for a predetermined dollar
amount, that is, $[(1/S)(1 + i£)]F
 Interest Rate Parity

The “effective” dollar interest rate

from the U.K. investment alternative
is given by
 Interest Rate Parity

Arbitrage equilibrium then

IRP is a manifestation of the law of

one price
 Interest Rate Parity

IRP is approximated using

 Interest Rate Parity

IRP provides a linkage between interest

rates in two different countries:
when the $ is at a forward discount, that
is, F > S (where F and S are $ prices of
foreign currency), iUS > iUK to compensate
for the depreciation of the $
 Interest Rate Parity: Example

Assume that an investor has $1,000,000

and several alternative but comparable
Swiss franc (SF) monetary investments.
The i$ is 8% p.a. (2% for 90 days) while the
iSF is 4% p.a. (1% for 90 days). The spot rate
is SF1.48/$ while the 90-day forward rate
is SF1.4655/$
 Interest Rate Parity

When IRP holds, you will be indifferent

between investing your money in the US
and investing in the U.K. with forward
hedging if IRP is violated, you will prefer
one to another
Interest Rate Parity (IRP)

● difference in national interest rates for

securities of similar risk & maturity should
be equal to opposite of forward rate
discount/ premium for foreign currency.

15
16
Covered Interest Arbitrage (CIA)

● invest in currency that offers

higher return on covered basis

17
Covered Interest Arbitrage (CIA)

18
Uncovered Interest Arbitrage (UIA)

● investors borrow in currencies w/

low interest rates & convert
proceeds into currencies w/ high
interest rates.

19
Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade

20
Purchasing Power
Parity
 Prices and Exchange Rates
Law of one price: product’s price is the
same in all markets
 Prices and Exchange Rates
Suppose the market between Japan and US
are competitive and efficient and that there are
no other costs associated with moving
products across these countries. Good X costs
¥183 in Japan while in the US, it is $2.05.
What is the expected spot ER under the law of
one price?
Absolute purchasing power parity

spot exchange rate is determined

by relative prices of similar basket
of goods
Relative purchasing power parity

relative change in prices between

countries determines change in
forex rate
Relative purchasing power parity

Difference between Japan’s

inflation vs US inflation:
e.g. Japan’s inflation is lower by
4% relative to US
RPP Example

● Suppose the expected inflation in

Indonesia is 5.50% while the expected
inflation in PH is 4.25%. If the current
exchange rate is IDR14,400/USD and
PHP48.10/USD, what then is the expected
IDR/PHP exchange rate of RPP holds?

27
BIG MAC INDEX
 Have fun with the BIG MAC INDEX
Exchange
Country Currency code Local Price rate
United Arab Emirates AED 14.75 3.6732
Argentina ARS 320.00 85.3736
Australia AUD 6.48 1.3000
Bahrain BHD 1.50 0.3770
Peru PEN 11.90 3.6207
Philippines PHP 142.00 48.0925
Poland PLN 13.08 3.7226
United States USD 5.66 1.0000
Determine the price of BIG MAC in USD, implied PPP, and Over/Under valuation
of foreign currencies against the USD
Big MAC: good candidate for the
application of the law of one price
● the product itself is nearly identical in
each market
● the product is a result of predominantly
local materials and input costs

30
Big MAC: good candidate for the
application of the law of one price
● Limitations:
● Big Macs cannot be traded across
borders, and costs and prices are
influenced by a variety of other factors in
each country market, such as real estate
rental rates and taxes
31
Exchange Rate Pass-Through

● Pass-through: The degree to which

the prices of imported and exported
goods change as a result of
exchange rate changes

32
Exchange Rate Pass-through: Example
● Assume that the price in U.S. dollars and Euros of a BMW
automobile produced in Germany and sold in the United States at
the spot exchange rate is calculated as follows:

● If the euro were to appreciate 20% versus the U.S. dollar, from
$1.00/€ to $1.20/€, the price of the BMW in the U.S. market should
theoretically rise to $_____? Suppose the price of BMW rise to just
$40,000, then the price increase is

33
Exchange Rate Pass-through: Example
● Exchange rate pass through then is

14.29
● Exchange rate pass through = = 0.71 or 71%
20

34
Exchange Rate Pass-Through: Example

Desktop PCs from the US are being imported by X Co., a

subsidiary of US-based PC maker at the price of USD180
per unit. (1) Find the price of PC in PHP if the initial spot
rate is PHP51.24/USD. (2) Suppose the PHP is to
depreciate by 5% against the USD and X Co. maintained
a retail price of PHP9,500. Find the degree of exchange
rate pass-through.
35
 The Fisher effect
nominal interest rates in each country are
equal to the required real rate of return plus
compensation for expected inflation

where
i = nominal rate of interest,
r = the real rate of interest
π = expected rate of inflation over the period of time for which funds are
to be lent
 The Fisher effect
The approximate form is

The Fisher effect applied to the United States

and Japan would be as follows:
 The 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
 The International Fisher effect
• Justification for the international Fisher effect is that investors
must be rewarded or penalized to offset the expected change
in exchange rates.

• For example, if a dollar-based investor buys a 10-year yen

bond earning 4% interest, instead of a 10-year dollar bond
earning 6% interest, the investor must be expecting the yen
to appreciate vis-à-vis the dollar by at least 2% per year
during the 10 years. If not, the dollar-based investor would
be better off remaining in dollars.
 The International Fisher effect
• The rationale for the IFE is that a country with a
higher interest rate will also tend to have a higher
inflation rate.
• This increased amount of inflation should cause the
currency in the country with a higher interest rate
to depreciate against a country with lower
interest rates
• Recall that
 The International Fisher effect
The percentage change in exchange rate is
approximately

% change in exchange rate = id –if

Where
id = domestic nominal interest rate
if = foreign nominal interest rate
 The International Fisher effect
Future spot exchange rate is approximated by

St /S0 = (1 +id)/(1+if)

Where
St = spot exchange rate in the future
S0 = current spot exchange rate
 The International Fisher effect
Suppose the IDR/USD spot rate is 14,000,
and the US interest rate is 2.0%, while
Indonesia is 6.0%. What would be future spot
rate for the USD?
 Forecasting Exchange Rates
1. Efficient Market Approach

• The current exchange rate has already reflected all

relevant information, such as money supplies,
inflation rates, trade balances, and output growth.
• The exchange rate will then change only when the
market receives new information
 Forecasting Exchange Rates
1. Efficient Market Approach

• Random walk hypothesis suggests that today’s

exchange rate is the best predictor of tomorrow’s
exchange rate.
 Forecasting Exchange Rates
2. Fundamental Approach

• Requires the use of models

• Sample model:
exchange rate is determined by three independent
(explanatory) variables: (i) relative money supplies, (ii)
relative velocity of monies, and (iii) relative national
output
 Forecasting Exchange Rates
2. Fundamental Approach
 Forecasting Exchange Rates
2. Fundamental Approach
 Forecasting Exchange Rates
2. Fundamental Approach

Another model:

Exchange rate = f(interest rate, inflation, and current

account balance)

S= α + β1INT + β2INF + β3CUR + μ

 Forecasting Exchange Rates
3. Technical Approach

• based on the premise that history repeats itself

 Forecasting in Practice

1. Foreign exchange forecasting

services
2. Short-term forecasts are typically
motivated by a desire to hedge a
receivable, payable, or dividend for
a period of perhaps three months
 Technical Analysis

● focus on price and volume data to

determine past trends that are expected to
continue into the future
● Exchange rate movements:
1. day-to-day movement
2. short-term movements
3. long-term movements
 Notes on Forecasting

● Cross-rate consistency -the

reasonableness of the cross rates implicit in
individual forecast
● Fundamentals do apply in the long term.
There is, therefore, something of a
fundamental equilibrium path for a
currency’s value.
 Notes on Forecasting

Noise

a variety of random events, institutional

frictions, and technical factors may cause
currency values to deviate significantly from
their long-term fundamental path
 Notes on Forecasting

● Stabilizing expectations: Market

participants continually respond to
deviations from the long-term path by
buying or selling to drive the currency back
to the long-term path.
 Exchange Rate Dynamics: Overshooting

Yellow Blue Red

Is the color of gold, Is the colour of the Is the color of
butter and ripe clear sky and blood, and
lemons. In the the deep sea. because of this
spectrum of It is located it has
visible light, between violet historically
yellow is found and green on been
between green the optical associated with
and orange. spectrum. sacrifice,
danger and
courage.
Using Forward Contracts for an MNC

Offsetting a Forward Contract. In some cases, an MNC may desire to offset a forward contract
that it previously created.

EXAMPLE: On March 10, Green Bay, Inc., hired a Canadian construction company to expand its office and agreed
to pay C$200,000 for the work on September 10. It negotiated a six-month forward contract to obtain C$200,000
at $0.70 per unit, which would be used to pay the Canadian firm in six months. On April 10, the construction
company informed Green Bay that it would not be able to perform the work as promised. Therefore, Green Bay
offset its existing contract by negotiating a forward contract to sell C$200,000 for the date of September 10.
However, the spot rate of the Canadian dollar had decreased over the last month, and the prevailing forward
contract price for September 10 is $0.66. Green Bay now has a forward contract to sell C$200,000 on September
10, which offsets the other contract it has to buy C$200,000 on September 10. The forward rate was $0.04 per unit
less on its sale than on its purchase, resulting in a cost of $8,000 (C$200,000 x $0.04).

If Green Bay, Inc., negotiates the forward sale with the same bank with which it negotiated
the forward purchase, then it may be able to request that its initial forward contract simply
be offset. The bank will charge a fee for this service, which will reflect the difference between
the forward rate at the time of the forward purchase and the forward rate at the time of the
offset. Thus, the MNC cannot ignore its original obligation; rather, it must pay a fee to offset
that obligation.

Using Forward Contracts for Swap Transactions. A swap transaction involves a spot
transaction along with a corresponding forward contract that will ultimately reverse the spot
transaction. Many forward contracts are negotiated for this purpose.

EXAMPLE: Soho, Inc., needs to invest 1 million Chilean pesos in its Chilean subsidiary for the production of
additional products. It wants the subsidiary to repay the pesos in one year. Soho wants to lock in the rate at which
the pesos can be converted back into dollars in one year, and it uses a one-year forward contract for this purpose.
Soho contacts its bank and requests the following swap transaction.

1. Today. The bank should withdraw dollars from Soho’s U.S. account, convert the dollars to 1 million pesos
in the spot market, and transmit the pesos to the subsidiary’s account.
2. In one year. The bank should withdraw 1 million pesos from the subsidiary’s account, convert them to
dollars at today’s forward rate, and transmit them to Soho’s U.S. account.

These transactions do not expose Soho to exchange rate movements because it has locked in the rate at which
the pesos will be converted back to dollars. However, if the one-year forward rate exhibits a discount then Soho
will receive fewer dollars later than it invested in the subsidiary today. Even so, the firm may still be willing to
engage in the swap transaction so that it can be certain about how many dollars it will receive in one year.

Non-Deliverable Forward Contracts. A non-deliverable forward contract (NDF) is often used

for currencies in emerging markets. Like a regular forward contract, an NDF is an agreement
regarding a position in a specified amount of a specified currency, a specified exchange rate,
and a specified future settlement date. However, an NDF does not result in an actual
exchange of the currencies at the future date; that is, there is no delivery. Instead, one party
to the agreement makes a payment to the other party based on the exchange rate at the
future date.

EXAMPLE: Jackson, Inc., an MNC based in Wyoming, determines as of April 1 that it will need 100 million Chilean
pesos to purchase supplies on July 1. It can negotiate an NDF with a local bank as follows. The NDF will specify
the currency (Chilean peso); the settlement date (90 days from now); and a reference rate, which identifies the
type of exchange rate that will be marked to market at the settlement. Specifically, the NDF will contain the following
information.

■ Buy 100 million Chilean pesos.

■ Settlement date: July 1.
■ Reference index: Chilean peso’s closing exchange rate (in dollars) quoted by Chile’s central bank in 90 days.

Assume that the Chilean peso (which is the reference index) is currently valued at $0.0020, so the dollar amount
of the position is $200,000 ($0.0020 x 100 million Chilean pesos) at the time of the agreement. At the time of the
settlement date (July 1), the value of the reference index is determined and then a payment is made from one party
to another in settlement. For example, if the peso value increases to $0.0023 by July 1, the value of the position
specified in the NDF will be $230,000 ($0.0023 x 100 million pesos). Since the value of Jackson’s NDF position is
$30,000 higher than when the agreement was created, Jackson will receive a payment of $30,000 from the bank.

Recall that Jackson needs 100 million pesos to buy imports. Since the peso’s spot rate rose from April 1 to July 1,
the company will need to pay $30,000 more for the imports than if it had paid for them on April 1. At the same time,
however, Jackson will have received a payment of $30,000 due to its NDF. Thus, the NDF hedged the exchange
rate risk.

Suppose that, instead of rising, the Chilean peso had depreciated to $0.0018. Then Jackson’s position in its NDF
would have been valued at $180,000 (100 million pesos x $0.0018) at the settlement date, which is $20,000 less
than the value when the agreement was created. In this case, Jackson would have owed the bank $20,000 at that
time. Yet the decline in the spot rate of the peso means that Jackson would also pay $20,000 less for the imports
than if it had paid for them on April 1. Thus, an offsetting effect occurs in this example as well.

The preceding examples demonstrate that, even though an NDF does not involve delivery, it
can effectively hedge the future foreign currency payments anticipated by an MNC.

Because an NDF can specify that any payments between the two parties be in dollars or some
other available currency, firms can also use NDFs to hedge existing positions of foreign
currencies that are not convertible. Consider an MNC that expects to receive payment in a
foreign currency that cannot be converted into dollars. The MNC may use this currency to
make purchases in the local country, but it may nonetheless desire to hedge against a decline
in the value of that currency over the period before it receives payment. Hence the MNC takes
a sell position in an NDF and uses the closing exchange rate of that currency (as of the
settlement date) as the reference index. If the currency depreciates against the dollar over
time, then the firm will receive the difference between the dollar value of the position when
the NDF contract was created and the dollar value of the position as of the settlement date.
It will therefore receive a payment in dollars from the NDF to offset any depreciation in the
currency over the period of concern.

Source:
Madura, Jeff (2015). International Financial Management, 12th ed. Stamford: Cengage
Learning.
Selected Exercises on Forex Market

1. Restate the following one-, three-, and six-month outright forward European term bid-
ask quotes in forward points:

2. Given the following information, what are the NZD/SGD currency against currency bid-
ask quotations?

3. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:

Swiss franc/dollar = SFr1.5971/$
Australian dollar/U.S. dollar = A$1.8215/$
Australian dollar/Swiss franc = A$1.1440/SFr

Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based
on these quotes? If there is an arbitrage opportunity, what steps would he take to
make an arbitrage profit, and how much would he profit if he has $1,000,000 available
for this purpose?

4. Compute the forward discount or premium for the 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.
Linear trend and multiple regression

The equation that describes a straight line through our sample of ordered pairs, known as a linear
equation, takes the form

We will use the following data to manually compute the equation that represents the relationship
between time and exchange rate on the assumption that time is the only determinant of exchange rate.
We will use the ordinary least squares method to estimate the slope and the intercept. The least
squares method is a mathematical procedure used to identify the linear equation that best fits a set of
ordered pairs. The line that best fits the ordered pairs is called the regression line. The procedure can be
used to find the values for b0 (the y-intercept) and b1 (the slope of the line).
Day (x) S1 (y)
1 50.897
2 50.856
3 50.686
4 50.582
5 50.604
6 50.702
7 50.626
8 50.513
9 50.507
10 50.86
11 51.118
12 51.174
13 51.32
14 51.215
15 50.947

The formula for determining the sample slope of a line is given as

The formula for determining the intercept of a line is given as

From these formulas, it follows that you need to have a (1) column for xy, that is, x multiplied by the
value of y and then getting its sum; (2) a column for x2 and then getting its sum. The n in this case is the
number of paired values of x and y (day and exchange rate, s1).
Your table will look something like this
Day (x) S1 (y) xy x2
1 50.897
2 50.856
3 50.686
4 50.582
5 50.604
6 50.702
7 50.626
8 50.513
9 50.507
10 50.86
11 51.118
12 51.174
13 51.32
14 51.215
15 50.947

Source of data: www.bsp.gov.ph

Proceed and complete those that are required in the formula: get the sum of x, the sum of y, the sum of
xy and the sum of x2. The first value you can estimate is the value of b 1 because you need to plug this
value in the given formula to calculate the value of b0.

After calculating the value of b1 and b0, respectively, your linear trend equation will be

S = b 0 + b1 x

So, if the estimated b0 and b1, are 0.30 and 0.60, respectively, your equation will be S = 0.30 + 0.60x. You
can now use this equation to estimate the value of S for, say, day 16 in which the value of x is 16.

Now use your estimated b0 and b1 to forecast the exchange rate for day 16.

Using gretl for windows:

1. Open your Excel file using the following: Click File, Open data, User file and locate the file in your
computer. Make sure that in the scroll menu All files is chosen so that it can open your excel file
2. When asked about the structure of data, choose Time-series and Time series frequency must be
Other
3. After this is done. Go to Model and click Ordinary least squares. You will then be brought to a
scroll down menu to specify the model. Highlight S1 and click the arrow for the dependent
variable. Highlight Day and click the arrow for regressors.
4. Click Ok. The gretl output generates the value (Coefficients) of the constant and the value for
Day. The constant is your intercept (b0) and the coefficient for Day is your b1. You should check
this against your results using the formulas given above.
5. Use the equation to forecast exchange rate for day 16, day 17, and so on.

References:

Donnelly, Robert A. (2015). Business statistics, 2nd ed. Boston: Pearson Education.
www.bsp.gov.ph
Multiple regression

The model:

ER = α + β1INT +β2CPI + μ

Where

ER = PHP/USD exchange rate

Data from the BSP website:

Year Month ER INT CPI
2018 Jan 50.509 2.484 114.100
2018 Feb 51.786 2.779 114.900
2018 Mar 52.068 3.125 115.500
2018 Apr 52.099 3.600 116.100
2018 May 52.195 3.769 116.100
2018 Jun 53.048 3.864 116.800
2018 Jul 53.433 4.125 117.400
2018 Aug 53.274 4.187 118.400
2018 Sep 53.942 4.502 119.500
2018 Oct 54.009 5.763 119.800
2018 Nov 52.808 6.144 119.600
2018 Dec 52.769 6.061 118.900
2019 Jan 52.468 6.019 119.100
2019 Feb 52.190 5.842 119.300
2019 Mar 52.413 5.938 119.300
2019 Apr 52.112 5.851 119.600
2019 May 52.262 5.669 119.800
2019 Jun 51.803 4.944 119.900
2019 Jul 51.143 4.261 120.200
2019 Aug 52.055 3.585 120.400
2019 Sep 52.105 3.414 120.600
2019 Oct 51.504 3.280 120.800
2019 Nov 50.727 3.330 121.100
2019 Dec 50.767 3.324 121.900
2020 Jan 50.839 3.583 122.600
2020 Feb 50.745 3.510 122.400
2020 Mar 50.904 3.406 122.300
2020 Apr 50.735 3.185 122.200
2020 May 50.556 2.373 122.300
2020 Jun 50.097 2.107 122.900
2020 Jul 49.468 1.689 123.500
2020 Aug 48.843 1.416 123.300
2020 Sep 48.506 1.544 123.400
2020 Oct 48.482 1.555 123.800
2020 Nov 48.252 1.463 125.100
2020 Dec 48.064 1.448 126.200
 Last check for updates: 30 Mar 2021
New update available: none (as of 30 Mar 2021)
Current update level: 21 Jan 2021 (what's new)

Possible actions

Do nothing; all files are up to date.

Output
Click tofrom
edit Stata 16
automatic update checking preferences

. import excel "C:\Users\resty\Documents\2nd sem AY2020 2021\ELE04 GLOBAL FINANCE\FX dataset.xlsx", sheet("dataset
> ") firstrow
(3 vars, 36 obs)

. regress ER INT CPI

Source SS df MS Number of obs = 36

F(2, 33) = 65.04
Model 70.2252716 2 35.1126358 Prob > F = 0.0000
Residual 17.8145911 33 .539836095 R-squared = 0.7977
Adj R-squared = 0.7854
Total 88.0398627 35 2.51542465 Root MSE = .73474

ER Coef. Std. Err. t P>|t| [95% Conf. Interval]

INT .6594438 .0920961 7.16 0.000 .4720729 .8468147

CPI -.2332792 .0481225 -4.85 0.000 -.3311852 -.1353733
_cons 76.97405 5.945114 12.95 0.000 64.87863 89.06948

Gretl output

Model 1: OLS, using observations 2018:01-2020:12 (T = 36)

Dependent variable: ER

Coefficient Std. Error t-ratio p-value

const 76.9741 5.94511 12.95 <0.0001 ***
INT 0.659444 0.0920961 7.160 <0.0001 ***
CPI −0.233279 0.0481225 −4.848 <0.0001 ***

Mean dependent var 51.36044 S.D. dependent var 1.586009

Sum squared resid 17.81459 S.E. of regression 0.734735
R-squared 0.797653 Adjusted R-squared 0.785390
F(2, 33) 65.04314 P-value(F) 3.55e-12
Log-likelihood −38.41877 Akaike criterion 82.83754
Schwarz criterion 87.58809 Hannan-Quinn 84.49561
rho 0.666339 Durbin-Watson 0.546700

Exchange rate determinants:

1. Inflation -CPI as proxy
2. Interest rate -proxied by T-bill rates

References:

Donnelly, Robert A. (2015). Business statistics, 2nd ed. Boston: Pearson Education.
www.bsp.gov.ph