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INTERNATIONAL FINANCE
MBA(FT)
TOPIC 07
Currency Options
Introduction
• Options are financial contracts that give the option buyer(holder) the right,
but not the obligation, to buy or sell a currency, stock, bond, commodity or
other asset or instrument at a specified price within a specific time period.
• Call Option:- Option to buy an asset
• Put Option:- Option to Sell an Asset
Styles of Option Contract
• European Option
• Can be exercised only on the expiration date
• American Option
• Can be exercised any time on or before the expiration date
Option Contract Terminology
• Strike Price (Exercise Price)
• Premium
• Expiration date
• Number of contracts available
• Tick Size
• Settlement
• Mark to Market
• Margin
• Open Interest
https://www1.nseindia.com/products/content/derivatives/curr_der/cd_contrac
t_specifications.htm#
Contract Specifications (NSE)
https://www1.nseindia.com/products/content/derivatives/curr_der/cd_contract_specifications.htm
Contract Specifications (NSE)
OTC Currency Options
• Selected Scheduled commercial banks are permitted to be market makers in
currency options since July 2003
• Resident Indians are allowed to be net buyers of option
• There are strict guidelines related to amount and tenor of option contracts
that a corporate can book.
• The amount and tenor of option contract has to be lower than or equal to the
amount and tenor of the underlying trade transaction.
Option Moneyness
• Moneyness of an option indicates whether the contract would result in a
positive cash flow, negative cash flow or zero cash flow at the time of
exercising it.
• In The Money (ITM)
• Out of The Money (OTM)
• At The Money (ATM) (near the money)
Option Moneyness
• In The Money (ITM)
• ITM Call Option: Spot Price > Strike Price
• ITM Put Option: Spot Price < Strike Price
• Out of The Money (OTM)
• OTM Call Option: Spot Price < Strike Price
• OTM Put Option: Spot Price > Strike Price
• At The Money (ATM) (near the money)
• ATM: Spot Price = Strike Price
Option Contracts at NSE
https://www.nseindia.com/option-chain
Option Payoffs
• Payoff means return from the derivative strategy with change in the spot
price of the underlying asset.
• There are 4 Vanilla Option Positions
1. Long Call
2. Short Call
3. Long Put
4. Short Put
Example:- Suppose the Strike Price (K) is Rs. 70 and Premium (P) is Rs. 1
Option Payoffs-Long Call (K=70, P=1)
Spot rate on expiry Pay off_long Call
67.00 -1.0000
67.50 -1.0000
68.00 -1.0000
68.50 -1.0000
69.00 -1.0000
69.50 -1.0000
70.00 -1.0000
70.50 -0.5000
71.00 0.0000
71.50 0.5000
72.00 1.0000
72.50 1.5000
73.00 2.0000
73.50 2.5000
74.00 3.0000
74.50 3.5000
Option Payoffs-Short Call (K=70, P=1)
Spot rate on expiry Pay off_Short Call
67.00 1.0000
67.50 1.0000
68.00 1.0000
68.50 1.0000
69.00 1.0000
69.50 1.0000
70.00 1.0000
70.50 0.5000
71.00 0.0000
71.50 -0.5000
72.00 -1.0000
72.50 -1.5000
73.00 -2.0000
73.50 -2.5000
74.00 -3.0000
74.50 -3.5000
Option Payoffs-Long Put (K=70, P=1)
Spot rate on expiry Pay off_long put
67.00 2.0000
67.50 1.5000
68.00 1.0000
68.50 0.5000
69.00 0.0000
69.50 -0.5000
70.00 -1.0000
70.50 -1.0000
71.00 -1.0000
71.50 -1.0000
72.00 -1.0000
72.50 -1.0000
73.00 -1.0000
73.50 -1.0000
74.00 -1.0000
74.50 -1.0000
Option Payoffs-Short Put (K=70, P=1)
Spot rate on expiry Pay off_short put
67.00 -2.0000
67.50 -1.5000
68.00 -1.0000
68.50 -0.5000
69.00 0.0000
69.50 0.5000
70.00 1.0000
70.50 1.0000
71.00 1.0000
71.50 1.0000
72.00 1.0000
72.50 1.0000
73.00 1.0000
73.50 1.0000
74.00 1.0000
74.50 1.0000
Option Payoffs
1. Long Call P𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥 𝑆 − 𝐾, 0 − 𝑃
2. Long P𝑢𝑡 𝑝𝑎𝑦𝑜𝑓𝑓 = 𝑀𝑎𝑥 𝐾 − 𝑆, 0 − 𝑃
3. 𝑆ℎ𝑜𝑟𝑡 𝐶𝑎𝑙𝑙 𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑃 − 𝑀𝑎𝑥(𝑆 − 𝐾, 0)
4. 𝑆ℎ𝑜𝑟𝑡 𝑃𝑢𝑡 𝑃𝑎𝑦𝑜𝑓𝑓 = 𝑃 − 𝑀𝑎𝑥(𝐾 − 𝑆, 0)
Option Strategies (Combinations)
Options Strategies mean use of multiple options with same or different
strikes and maturities.
The transaction objective is to reduce overall premium payout while having
following market views;
a) Moderately bullish or bearish
b) Range bound
c) Breakout on either side
Moderately Bullish or Bearish View
1. Bull Call Spread
2. Bull Put Spread
3. Bear Put Spread
4. Bear Call Spread
Range Bound View
5. Short Strangle
6. Short Straddle
7. Long Butterfly
Breakout View
8. Long Strangle
9. Long Straddle
10. Short Butterfly
Strategies complementing existing position in future market
11. Covered Call
12. Covered Put
13. Protective Call
14. Protective Put
Option Strategies-Bull Call Spread
Assume that Current USDINR SPOT rate is 72.6
You have a view that in coming days it should trade around 73.5
(Moderately Bullish)
Your objective is to participate in the profit if the view turns correct
At the same time you also want to reduce the net premium payment(cost).
To reduce the cost, you are okay to let go of any profit that may accrue to
you beyond 73.75.
To execute the strategy, Buy ATM or ITM Call and sell one OTM Call
according to your view and the premium
Option Strategies-Rates
CALL LTP STRIKE PRICE PUT LTP
3.1015 71 0.0125
2.8555 71.25 -
2.5 71.5 0.0025
2.22 71.75 0.0075
1.2125 72 0.005
1.055 72.25 0.0075
0.95 72.5 0.0175
0.72 72.75 0.0325
0.495 73 0.06
0.3125 73.25 0.135
0.195 73.5 0.2675
0.125 73.75 0.45
0.075 74 0.6425
0.0425 74.25 0.855
0.0325 74.5 1.25
0.015 74.75 1.5725
Current Spot Rate (USD/INR) 72.6
View Buy Sell
Bull Call Spread Moderately Bullish ATM/ITM Call OTM Call
Strike Price 72.25 73.75
Premium 1.055 0.125
Net Premium Paid (When Spot Price is at or below
Maximum Loss
lower Strike Price
Maximum Profit (Higher K - Lower K - Net Premium Paid)
Breakeven Point Lower Strike Price + Net Premium
Option Strategies-Bull Put Spread

View Buy Sell
Bull Put Spread Moderately Bullish OTM Put ATM Put
Premium 0.1 0.8
Maximum Loss (Higher K - Lower K - Net Premium Paid)
Maximum Profit Net Premium Received
Breakeven Point Higher Strike price - Net Premium received

Option Strategies-Bull Put Spread
Option Strategies-Bear Put Spread

View Buy Sell
Bear Put Spread Moderately Bearish ITM Put OTM Put
Premium 0.1 0.05
Maximum Loss Net Premium Paid
Breakeven Point Higher Strike price - Net Premium paid
Option Strategies-Bear Put Spread
Option Strategies-Bear Call Spread

View Buy Sell
Bear call Spread Moderately Bearish OTM Call ATM Call
Strike Price 74 72.5
Premium 0.1 1
Breakeven Point Higher Strike price - Net Premium paid
Option Strategies-Bear Call Spread
Option Strategies-Short Strangle

View Sell Sell
Short Strangle Range Bound OTM Call OTM PUT
Strike Price 73 72
Premium 0.5 0.1
Maximum Loss Could be unlimited if price moves outside the boundaries
Maximum Profit Total Premium
Breakeven Point Higher Strike price + Premium or lower Strike Price- Premium
Option Strategies-Short Strangle
Option Strategies-Short Straddle

View Sell Sell
Short Straddle Range Bound ATM PUT ATM CALL
Premium 1 0.2
Maximum Loss Could be unlimited if price moves outside the boundaries
Maximum Profit Total Premium (if Spot=Strike)
Breakeven Point Strike price + Premium or Strike Price- Premium
Option Strategies-Short Straddle
Option Strategies-Long Butterfly
View Buy Buy Sell Sell
Long Buterfly Range Bound ITM Call OTM Call ATM Call ATM CALL
Strike Price 72 73.5 72.5 72.5
Premium 1.1 0.2 1 1
Maximum Profit Middle K – Lowest K + premium received – Premium Paid
Breakeven Point Highest Strike price-net premium and lowest strike price + net Premium
Option Strategies-Long Butterfly
Option Strategies-Long Strangle
View Buy Buy
Long Strangle Break Out OTM Call OTM Put
Strike Price 73 72
Premium 0.5 0.01
Maximum Loss Total Premium Paid
Maximum Profit Unlimited
Breakeven Point Strike price +/- Premium on each side
Option Strategies-Long Strangle
Option Strategies-Long Straddle
View Buy Buy
Long Straddle Break Out ATM Call ATM Put

Premium 0.95 0.05
Maximum Loss Total Premium Paid
Maximum Profit Unlimited
Breakeven Point Strike price +/- Premium on each side
Option Strategies-Long Straddle
Option Strategies-Short Butterfly
View Sell Sell Buy Buy
Short Buterfly Breakout ITM Call OTM Call ATM Call ATM CALL
Strike Price 71.5 73.5 72.5 72.5
Premium 2.5 0.195 1 1
Maximum Loss Lowest Strike – Middle Strike + Net Premium
Maximum Profit Net Premium Received
Breakeven Point Lower Strike - Net Premium and Higher Strike + Net premium
Option Strategies-Short Butterfly
Strategies Complementing existing position in future market
1. Covered Call- [Long in Future + OTM Short Call]

2. Covered Put- [Short in Future + OTM Short Put]
3. Protective Call- [Short in Future + OTM Long Call]
4. Protective Put- [Long in Future + OTM Long Put]
Basics of option pricing
Following are the determinants of Options Price/ Value (Premium)

1. Spot of Underlying
2. Strike Price
3. Annualized Volatility
4. Time to Expiration
5. Risk Free Rate of Interest on both currencies
Basics of option pricing
Determinant Value of Call Option Value of Put Option
Spot FX Rate Increase Decrease
Strike Price Decrease Increase
Interest Rate Increase Decrease

Differential
Volatility Increase Increase
Time to Expiration Increase Increase

MBA(FT)
TOPIC 06
Currency Futures
Introduction
• In terms of PRICING, FUNDAMENTALS and APPLICATIONS, Futures are
identical to Forwards.
• Futures differ substantially from Forwards in terms of their MARKET,
OPERATIONS and SETTLEMET.
• Currency Futures came into existence around 1970.
Introduction
• In terms of PRICING, FUNDAMENTALS and APPLICATIONS, Futures are
identical to Forwards.
• Futures differ substantially from Forwards in terms of their MARKET,
OPERATIONS and SETTLEMET.
• Currency Futures came into existence around 1970.
Limitation of Forward Contract
• Fairness of forward price.
• Negotiation of price in OTC contracts is always subject to the relative bargain power of
the counterparties involved.
• Forward exchange rate becomes the function of relative strength of the two parties
and it favours the stronger one.
• Free Flow of information
• Information on Price, Volume and trends in OTC market is not readily available which
makes price discovery less efficient
• Delivery based system
• Counterparty Risk
Forward Vs. Future
Forward Vs. Future
Future Contract Terminology
• Contract Size
• Contract Expiry
• Number of contracts available
• Price quotation
• Tick Size
• Settlement
• Mark to Market
• Margin
• Open Interest
Future Contract Specifications (NSE)
https://www1.nseindia.com/products/content/derivatives/curr_der/cd_contract_specifications.htm
Future Contracts at NSE
https://www.nseindia.com/market-data/currency-derivatives
Margin on Various Contract
https://zerodha.com/margin-calculator/Currency/
Pricing of Future Contract
(𝑟−𝑟𝑓 )×𝑇
•𝐹0 = 𝑆0 × 𝑒
• F0 = Theoretical futures price
S0 = Value of the underlying
r = Cost of financing (using continuously compounded interest rate)
rf = Foreign risk free interest rate
T = Time till expiration (in years)
e = 2.71828
Future SPREAD
• Spread in other markets involve two transactions; spot and
future in near month and far month.
• Currency Spot markets are not available for retail traders
• Hence, spread in currency markets involve both the
long/Short transactions in future contracts.
• There are two types of Spread transactions in Futures:
1. Future Bull Spread:-Buying NEAR month and selling
FAR month contract
2. Future Bear Spread:-Selling NEAR month and Buying
FAR month contract
https://zerodha.com/varsity/chapter/the-usd-inr-pair-part-
2/#:~:text=Well%2C%20this%20is%20fairly%20easy,as%20the%20'Calendar%20Spread'.&text=As%20of%20today%20the%20
USD,contract%20is%20trading%20at%2067.6900.
Calendar SPREAD Contracts at NSE
• Margins in Calendar Spread
Calendar SPREAD Contracts at NSE
https://www.nseindia.com/market-data/currency-derivatives
Calendar SPREAD-Example
1 st April 20th April
Contract LTP Current Spread LTP Expected Spread
28-Apr-21 72.9000 73.2000
27-May-21 73.5525 73.4525
Contract LTP Current Spread Expected Spread
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525
Bull Spread Bear Spread

Buy 1000 USD in April Sell 1000 USD in April
Sell 1000 USD in May Buy 1000 USD in May
Difference Difference
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Buy 1000 USD in April -72,900.00 Sell 1000 USD in April -73,452.50
Sell 1000 USD in May 73,552.50 Buy 1000 USD in May 73,200.00
Difference Difference
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Difference 652.50 Difference -252.50
28-Apr-21 72.9000 73.2000
0.6525 0.2525
27-May-21 73.5525 73.4525

Difference 652.50 Difference -252.50 400.00
Current Spread Expected Spread
0.6525 0.2525
Difference
Buy Spread Sell Spread
652.50 -252.50 400.00
Using Futures for Hedging Foreign Exchange Risk
• Short the receivable currency
• Long the payable currency
MBA(FT)
TOPIC 02
International Monetary System
International Monetary System
• Determination of exchange rate for currencies of various nations has
always been interesting.
• Over several centuries, the issue of how much is the worth of one
currency in terms of another has been the central thought for traders
and speculators.
• For several centuries, economists have struggled to find a mechanism
for settlement of trade within and outside a nation.
• This topic discusses the history of development in the monetary
systems that evolved over a period of time.
Old Barter System
• International trade has been going on from the primitive time, even
when there existed no currency or money.
• When there was no currency, the mode of settlement of trade had
been the barter system.
• In barter system, a certain quantity of goods was exchanged for other
goods as a trade settlement.
• Even in modern-day society, trade on barter takes place where
nations adopt exchange of oil for food grains, arms or medicines, etc.
• Along with logistics, the biggest problem in barter system was , lack
of common denominator.
Gold Specie Standard
• Inconvenience of barter system forced traders to find a common
denominator in which value of goods can be established.
• As a result, gold coins evolved as the medium of exchange for
settlement of trade
• Gold became popular medium of exchange because of the following
reasons
• Durability
• Storability
• Portability
• Divisibility
• Standardizability
Classical Gold Standard
• Britain started the gold standard
• Paper or coin currencies were convertible into gold, at a specified
fixed rate
• In 1873, most countries started following gold standard
• The currencies issued by different countries were convertible into
gold at fixed rates
• The determination of exchange rate was simple and straight forward.
• USD 20.67 = 1 ounce gold
• GBP 4.2474 = 1 ounce gold
• Implies, GBP 1 = USD 4.8665
• This continues till world was –I (1914)
Classical Gold Standard
1704 The British West Indies 'de facto' following Queen Anne's proclamation.
Kingdom of Great Britain 'de facto' following Isaac Newton's revision of the mint ratio, at 1 guinea to 129.438 grains (8.38 g) of 22
1717 carat crown gold.
1821 United Kingdom 'de jure' at one sovereign to 123.27447 grains of 22 carat crown gold,
1818 Netherlands at 1 guilder to 0.60561 g gold.
Canada in conjunction with the American Gold Eagle coin equal to ten US dollars and also the British gold sovereign equal to four
1853 dollars eighty-six and two-thirds cents. The Canadian unit was made equal to the American unit in the year 1858.
1854 Portugal at 1000 réis to 1.62585 g gold.
1873 German Empire at 2790 Goldmarks to 1 kg gold.
1873 United States 'de facto' at USS20.67 to 1 troy oz (31.1 g) gold. Belgium, Italy, Switzerland, and France at 31 francs to 9.0 g gold.
1875 Denmark, Norway, and Sweden at 2480 kroner to 1 kg gold,
1876 France who founded Latin Monetary Union in 1865 fixed the value of franc at 0.2903 gm of gold,
1876 Spain at 31 pesetas to 9,0 g gold.
1878 Grand Duchy of Finland at 31 marks to 9.0 g gold.
1879 Austrian Empire.
1881 Argentina at 1 peso to 1.4516 g gold.
1885 Egypt fixed the value of its currency Egyptian pound to 7.4375 gm of gold.
1897 Russia at 31 roubles to 24.0 g gold.
1897 Japan at 1 yen devalued to 0.75 g gold.
1898 India when its silver rupee was pegged to pound sterling at I s 4d.
1903 The Philippines gold exchange/US dollar.
Variants of Gold Standard
• Gold Specie Standard

• Monetary unit is associated with circulating gold coins.
• Gold Bullion Standard
• The circulating currency is not gold but the monetary unit is convertible into
gold at a fixed rate.
• Gold Exchange Standard
• The countries issuing the currency undertakes to convert it into another
currency that is on gold bullion at a predetermined rate.
How Gold Standard Works
• The major advantage of gold standard was its feature of self-
correction and adjustment of international trade, which led to the
stability of prices and balanced trade.
• The gold standard would operate automatically and restore the
balance through price adjustment and flow of gold from one country
to another.
• Beyond the scope of fiscal and monetary policies that dominate and
guide the economic growth and development in modern days, no
such elaborate policy changes were required in the era of gold
standard.
Self Correcting Mechanism Under Gold Standard
Example
Increased productivity leads to
increased production and reduced price of goods and services
Export becomes competitive and import becomes less attractive
Increase in export and decrease in imports
Increase in flow of gold to the country
Increase in the money supply
Increase in prices of goods and services
Decrease in export and increase in imports
Balance of Payments corrected
Self Correcting Mechanism Under Gold Standard
Example
• Unlike modern time, under the gold standard, the aggregate amount
of currencies would remain same. (Except fresh mining of gold)
• The self correcting mechanism of gold standard rests on the following
principles;
• Free flow of gold across nations
• The currency circulation is proportional to the gold reserves of a country
• Quantity theory of money applies.
Prices under Gold Standard
• The greatest advantage of gold standard is its ability to keep inflation

at near zero level.
• The self correcting mechanism implies that while there would be
inflation in one part of the world, the other half will face deflation
• This kept the overall price level constant in the long run. Inflation and
deflation were short-run temporary phases.
• For about 200 years (1700s to 1914), the prices remained constant
Prices under Gold Standard
• Inflation has been a global phenomenon since abandonment of gold

standard
• At the same time, money expansion and economic growth were
limited to fresh mining of gold. (trade off between price stability and
economic growth)
• 1930 depression
• Inflation can be corrected in the short run but
• It takes time to increase consumption
The End of World War-I and Fiat Money
• Many saw gold standard as a constraining factor for development as it
did not allow for expansionary policies.
• Nations needed money for financing was and rehabilitation.
• Fiat Money:
• Issue of excess money without having the requisite gold.
• Issued by the governments on faith and not backed by tangible gold.
• After world war-I fiat money became widespread phenomenon for
the war-torn countries trying to rebuild nations.
1922 Genoa Conference
• After World War-II, countries tried to re-establish the gold standard
with the same gold parity that existed in the pre-world war period
• In 1922, gold standard was re-introduced as gold exchange standard
• Under the new gold exchange standard;
• US and England could hold gold as reserve whereas other countries could
have gold, dollar and pound as reserves.
• The international settlement could be done in gold, dollars and pounds
Collaps of Gold Standard
• There was accumulation of gold, dollars and pounds under the
managed gold standard.
• USA started accumulating large reserves of gold because of trade
surplus.
• Gold reserves across Europe depleted but money supply kept
increasing
• England devalued pound in 1930 and initiated competitive
devaluations across Europe. One country after another devalued its
currency to gain competitive edge over others to increase exports.
• This was virtual collapse of gold standard.
Bretton Woods System
• 1930 meeting in Bretton Woods, USA was a founding stone in
establishing a new mechanism of exchange rates
• It was called Bretton Woods System.
• An attempt was made to eliminate following problems;
• Hyperinflation in Germany
• Depression in USA
• Competitive Devaluations
• https://www.youtube.com/watch?v=RtFz9q26t5A
Bretton Woods System-FEATURES
The system was implemented in 1946. According to the system
• Each government was to fix the exchange rate of its currency in terms of US
dollars or gold, referred to as par value
• The US dollar was convertible into gold. The value of gold was fixed at $35
per oz.
• Monetary authorities in each country were obligated to defend the
exchange rate fixed in a band of +/- 1%. This was known as adjustable peg.
• The exchange rate within the band would be maintained by the central
banks with intervention of buying and selling of USD as the case may be.
• The US dollar required by the country would be provided by the IMF
(against the gold pledged by each nation)
• Temporary exchange rate instability would be overcome by central
bank intervention.
• In case the country is unable to defend the exchange rate within the
band due to fundamental disequilibrium. It could adjust the par value
by +/- 5% subject to approval from the IMF.
Bretton Woods System-Adjustment
Progress of Bretton Woods System
• At the time of introduction of BWS, USA was very sound with BoP
surplus and huge gold reserves. This was because of its exports to
Europe.
• European countries were running he deficits
• Due to this, in 1947, several countries (England, France, Scandinavian
countries) realized that their currencies were overvalued.
• As a result several devaluations of par value took place to make
export competitive.
• Things changed rapidly and 1950 saw reversals of BoP.
• Trade Balance of USA started running negative whereas trade balance of
Japan and Europe started running to surplus.
• Capital controls across Europe started vanishing.
• Because of mounting prices of gold, there was loss of confidence in the
ability of dollar to convert the liabilities into gold.
• In 1962, system of gold pool was devised by the UK, France, Germany, Italy
to repose faith in gold and dollar.
• Vietnam was added to the loss of confidence.
• In 1967, british pound was devalued by 14.6% and FF by 11%
• In 1971 USA made several announcement that made the system
collapse.
• 10% duty on imports.
• Dollar was no more convertible into gold.
• Price and wage control across US.
• USA didn’t want its currency to devalue but other currencies to
revalue.
• Other currencies preferred to float.
• In 1971 USA owned $88 bn in short-term liabilities due to consistent BoP
deficit (against the gold worth $12bn)
• To save BWS, Several last minute measures were announced
• Dollar was devalued by 8.87% ($38.05 per oz of gold)
• Countries with surplus BoP were asked to revalue upward.
• Fluctuation margin of 2.25% was allowed.
• USA agreed to remove 10% duty.
• In spite of all these, by 1972, USAs trade deficit reached to a record level of
$9.80 bn on current account.
• It devalued USD further to USD 42.222 per oz of gold.
• In 1976, Jamaica agreement was signed to legalize the floating exchange
rate and demonetization of gold as the currency of reserve.
MBA(FT)
TOPIC 01
INTRODUCTION
Multinational Corporations
• MNCs are firms that engage in some form of international business.
• GOAL: MNC’s managers conduct international financial management,
which involves international investing and financing decisions that are
intended to maximize the value of the MNC.
• Most known MNCs have more than half of their assets in foreign
countries.
• International Finance is also relevant for purely domestic companies
• Because these companies must recognize how their foreign
competitors will be influenced by movement in exchange rates,
foreign interest rates, labor costs and inflation
Common Finance Decisions
• whether to discontinue operations in a particular country,
• whether to pursue new business in a particular country,
• whether to expand business in a particular country, and
• how to finance expansion in a particular country.
What’s Special about International Finance
• Foreign Exchange Risk
• Political Risk
• Market Imperfections
• Expanded Opportunity Set
Agency Problem
• Managers may make decisions that conflict with the firm’s goal of
maximizing shareholders wealth.
• Ex.: decision to establish subsidiary on the basis of appeal of the location or desire to
have higher compensation.
• The cost of ensuring that managers maximize shareholder wealth is agency
cost
• Agency costs are normally larger for MNCs than domestic firms due to the
following reasons;
• Monitoring managers of distant subsidiaries in foreign countries is more difficult.
• Foreign subsidiary managers raised in different cultures may not follow uniform
goals.
• Sheer size of larger MNCs can create large agency problems.
Agency Problem-Example
• Few years ago, Seattle Co. (based in the United States) established a
subsidiary in Singapore so that it could expand its business there. It hired a
manager in Singapore to manage the subsidiary.
• During the immediate 2 years, the sales generated by the subsidiary had
not grown. Yet, the manager of the subsidiary had hired several employees
to do the work that he was assigned.
• The managers of the parent company in the United States had not closely
monitored the subsidiary because they trusted the manager of the
subsidiary and because the subsidiary was so far away.
• Then they realized that there was an agency problem. The subsidiary was
experiencing losses every quarter, so they needed to more closely monitor
the management of the subsidiary.
Management Structure of MNC
• Centralized: Allows managers of the parent to control foreign
subsidiaries and therefore reduce the power of subsidiary managers
• Decentralized : Gives more control to subsidiary managers who are
closer to the subsidiary’s operation and environment
Management Structure of MNC-Centralized
Management Structure of MNC- Decentralized
Why Firms Pursue International Business
• Theory of Competitive Advantage:
• specialization increases production efficiency.
• Imperfect Markets Theory:
• factors of production are somewhat immobile providing incentive to seek out
foreign opportunities.
• Product Cycle Theory:
• as a firm matures, it recognizes opportunities outside its domestic market.
Why Firms Pursue International Business
Product Cycle Theory
How Firms Engage in International Business
• International trade
• Licensing
• Franchising
• Joint Ventures
• Acquisitions of existing operations
• Establishing new foreign subsidiaries
International Trade
• Relatively conservative approach that can be used by firms to
• penetrate markets (by exporting)
• obtain supplies at a low cost (by importing).
• Minimal risk – no capital at risk
Licensing
• Obligates a firm to provide its technology (copyrights, patents,
trademarks, or trade names) in exchange for fees or some other
specified benefits.
• Allows firms to use their technology in foreign markets without a
major investment and without transportation costs that result from
exporting
• Major disadvantage: difficult to ensure quality control in foreign
production process
Franchising
• Obligates firm to provide a specialized sales or service strategy,
support assistance, and possibly an initial investment in the franchise
in exchange for periodic fees.
• Allows penetration into foreign markets without a major investment
in foreign countries.
Joint Ventures
• A venture that is jointly owned and operated by two or more firms. A
firm may enter the foreign market by engaging in a joint venture with
firms that reside in those markets.
• Allows two firms to apply their respective cooperative advantages in a
given project.
Acquisitions of Existing Operations
• Acquisitions of firms in foreign countries allows firms to have full
control over their foreign businesses and to quickly obtain a large
portion of foreign market share.
• Subject to the risk of large losses because of larger investment.
• Liquidation may be difficult if the foreign subsidiary performs poorly.
Valuation Model for MNCs-Domestic Model
n
 E CF$,t 
V   t 
t 1  1  k  
Where
 V represents present value of expected cash flows
 E(CF$,t) represents expected cash flows to be received at
the end of period t (from US Perspective),
 n represents the number of periods into the future in
which cash flows are received, and
 k represents the required rate of return by investors.
Valuation Model for MNCs-Multinational Model
Dollar Cashflows

E CF$,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.
Valuation Model for MNCs-Multinational Model
Firm Value
 E CF  E S 
m
n j ,t j ,t
V 
j 1
t 1 1  k  2
How an MNC’s Valuation is Exposed to Uncertainty

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INTERNATIONAL FINANCE

Current Spot Rate (USD/INR) 72.6

Maximum Loss (Higher K - Lower K - Net Premium Paid)

Maximum Profit Net Premium Received

Breakeven Point Higher Strike price - Net Premium received

Current Spot Rate (USD/INR) 72.6

Current Spot Rate (USD/INR) 72.6

Current Spot Rate (USD/INR) 72.6

Current Spot Rate (USD/INR) 72.6

Strike Price 72.5 72.5

1. Covered Call- [Long in Future + OTM Short Call]

Following are the determinants of Options Price/ Value (Premium)

Spot FX Rate Increase Decrease

Strike Price Decrease Increase

Interest Rate Increase Decrease

Time to Expiration Increase Increase

Bull Spread Bear Spread

Bull Spread Bear Spread

Bull Spread Bear Spread

Bull Spread Bear Spread

• Gold Specie Standard

• The greatest advantage of gold standard is its ability to keep inflation

• Inflation has been a global phenomenon since abandonment of gold

 Sj,t represents the exchange rate at which the foreign

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