MBA IV SEMESTER (FINANCE)

INTERNATIONAL FINANCIAL MANAGEMENT

UNIT 2
INTERNATIONAL FINANCIAL MARKETS
BASIC CONCEPTS IN THE MODULE

1. Arbitrage: Action to capitalize on a discrepancy in quoted prices; in many cases, there is no

investment of funds tied up for any length of time.

2. Asian dollar market: Market in Asia in which banks collect deposits and make loans
denominated in US dollars.

3. Ask price: Price at which a trader of foreign exchange (typically a bank) is willing to sell a
particular currency.

4. Bid price: Price that a trader of foreign exchange (typically a bank) is willing to pay for a
particular currency.

5. Bid/ask spread: Difference between the price at which a bank is willing to buy a currency and
the price at which it will sell that currency.

6. Covered interest arbitrage: Investment in foreign money market security with a simultaneous
forward sale of the currency denominating that security.

7. Direct quotations: Exchange rate quotations representing the value measured by number of
dollars per unit.

8. Discount: As related to forward rates, represents the percentage amount by which the forward
rate is less than the spot rate.

9. Eurobanks: Commercial banks that participate as financial intermediaries in the Eurocurrency

market.

10. Eurobonds: Bonds sold in countries other than the country represented by the currency
denominating them.

11. Euro-commercial paper: Debt securities issued by MNCs for short-term financing.

12. Eurocredit loans: Loans of one year or longer extended by Eurobanks.

13. Eurocredit market: Collection of banks that accept deposits and provide loans in large
denominations and in a variety of currencies. The banks that comprise the Eurocurrency
market; the difference is that the Eurocredit loans are longer term than so-called Eurocurrency
loans.

14. Eurocurrency market: Collection of banks that accept deposits and provide loans in large
denominations and in a variety of currencies.

15. Eurodollar: Term used to describe US dollar deposits placed in banks located in Europe.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 1

 16. Foreign exchange market: Market composed primarily of banks, serving firms and consumers
who wish to buy or sell various currencies.

17. Forward contract: Agreement between a commercial bank and a client about an exchange of
two currencies to be made at a future point in time at a specified exchange rate.

18. Forward discount: Percentage by which the forward rate is less than the spot rate; typically
quoted on an annualized basis.

19. Forward premium: Percentage by which the forward rate exceeds the spot rate; typically quoted
on an annualized basis.

20. Hedge: To insulate a firm from exposure to exchange rate fluctuations.

21. Money market hedge: Use of international money markets to match future cash inflows and
outflows in a given currency.

22. Petrodollars: Deposits of dollars by countries that receive dollar revenues due to the sale of
petroleum to other countries; the term commonly refers to OPEC deposits of dollars in the
European market.

23. Premium: As related to forward rates, represents the percentage amount by which the forward
rate exceeds the spot rate. As related to currency options, represents the price of a currency
option.

24. Spot market: Market in which exchange transactions occur for immediate exchange.

25. Spot rate: Current exchange rate of currency.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 2

 Theme of this Module
• Finance managers must understand various financial markets that are available so that they can
use those markets to facilitate their international transactions.
• Major international financial markets:
o Foreign exchange market
o International money market
o International credit market
o International bond market
o International stock market
FOREIGN EXCHANGE MARKET
• Market that allows for the exchange of one currency for another.
• Large commercial banks serve this market who
o Hold investments of each company
o Accommodate requests by individuals or MNCs
• Companies normally exchange one currency for another through commercial banks over a
telecommunications network.
• Exchange rate: For one currency to be exchanged for another currency, there needs to be an
exchange rate that specifies the rate at which one currency can be exchanged for another.
• The system for establishing exchange rates can be changed over time:
o Gold Standard (1875-1914)
o Agreement on Fixed Exchange Rates (The Bretton Woods Agreement 1945-1972)
o Floating Exchange Rate System (Since 1973)
A. Gold Standard
• Each currency was convertible into gold at a specified rate (1876-1913).
• The exchange rate between two currencies was determined by their relative convertibility
rates per ounce of gold.
• Gold standard was suspended when World War I began (1914)
• Some countries reverted to the gold standard in 1920, but abandoned due to Great
Depression.
• In 1930, some countries attempted to peg their currency to the $ or £, but there were
frequent revisions.
B. Agreements on Fixed Exchange Rates
• International Agreement (Bretton Woods Agreement 1944) called for fixed exchange
rates between currencies. During this period (1944-1971) governments would intervene
to prevent exchange rates from moving from than 1% above or below their established
levels.
• By 1971 the US $ appeared overvalued; foreign demand for $ was substantially less.
• Representatives of major nations met to discuss this dilemma (Smithsonian Agreement
1971)
o US $ was devalued relative to the other major currencies.
o Exchange rates were allowed to fluctuate by 2.25% in either direction from the
newly set rates.
o This was the first step in letting market forces determine appropriate price of
currency.
C. Floating Exchange Rate System
• Governments found difficulty in maintaining exchange rates within the stated boundaries.
• The more widely traded currencies were allowed to fluctuate in accordance with market
forces (March 1973).
PARTICIPANTS IN FOREIGN EXCHANGE MARKET
• Arbitrageurs Arbitrageurs seek to earn risk-less profits by taking advantage of
differences in exchange rates among countries:

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 3

 • Traders Traders engage in the export or import of goods to a number of countries. They
operate in the foreign exchange market because exporters receive foreign currencies
which they have to convert into local currencies, and importers make payments in foreign
currencies which they purchase by exchanging the local currency. They also operate in
the foreign exchange market to hedge their risk.
• Hedgers Multinational firms have their operations in a number of countries and their
assets and liabilities are designated in foreign currencies. The foreign exchange rates
fluctuations can cause diminution in the home currency value of their assets and
liabilities. They operate in the foreign exchange market as hedgers to protect themselves
against the risk of fluctuations can cause diminution in the home currency value of their
assets and liabilities. They operate in the foreign exchange market as hedgers to protect
themselves against the risk of fluctuations in the foreign exchange rates.
• Speculators Speculators are guided purely by the profit motive. They trade in foreign
currencies to benefit from the exchange rate fluctuations. They take risks in the hope of
making profits.
FOREIGN EXCHANGE TRANSACTIONS
A. The Spot Market B. The Forward Market C. Currency Futures & Options
A. THE SPOT MARKET
• It is a market in which exchange transactions occur for immediate exchange.
• The average daily foreign exchange trading by banks around world now exceeds $1.5 trillion.
• Hundreds of banks facilitate foreign exchange transactions, the prominent one are Deutsche
Bank (Germany), Citibank (US) and J P Morgan Chase.
• Banks in London, New York and Tokyo are the largest foreign exchange trading centers.
• Commercial transactions between countries are often done electronically, and the exchange
rate at the time determines the amount of funds necessary for transmission.
• If a bank begins to experience a shortage in a particular foreign currency, it can purchase that
currency from other banks (Interbank market).
• Some MNCs rely on an online currency trader that serves as an intermediary between the
MNC and member banks. One popular online currency trading is Currenex.
• The US $ is commonly accepted as a medium of exchange by merchants in many countries.
• Although foreign exchange trading is conducted only during normal business hours in a given
location, these hours vary among locations due to different time zone. Several US banks have
established night trading desks.
• Spot Market Liquidity
o The more willing buyers and sellers there are, the more liquid the market is.
Ex: Euro, the British £, Japanese Yen
o The spot markets for currencies of LDCs are less liquid.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 4

FOREIGN EXCHANGE QUOTATIONS
1. Spot market interaction among banks
• The exchange rate between two currencies should be similar across various banks.
• If there is a discrepancy, customers or other banks:
o Purchase large amounts of currency from whatever bank quotes a relatively low
price.
o Sell to whatever bank quotes a relatively higher price.
• These actions cause adjustments in the exchange rate quotation.
2. Bid/Ask Spread of Banks
• Bid Price (Quote): Price that a bank is willing to pay for buying a particular currency.
• Ask Price (Quote): Price that a bank is willing to sell a particular currency
• Bid/Ask Spread: Represents the differential between bid and ask quotes and is intended to
cover the costs of foreign exchange transaction.
• Bid/Ask spread is expressed as a percentage of the ask quote.
Bid/Ask spread = (Ask rate – Bid rate)/Ask rate
• Spread = f (Order costs, Investing Costs, Competition, Volume, Currency)

INTERPRETING FOREIGN EXCHANGE QUOTATIONS

ERQs for widely traded currencies are published in The Wall Street Journal and in business section of
many newspapers on a daily basis
I. Direct Versus Indirect Quotations
II. Cross Exchange Rates

Direct Versus Indirect Quotations

Direct Quotations Indirect Quotations
Quotations that represent the value of a foreign Quotations that represent the number of units of
currency in $ terms i.e. number of dollars per foreign currency per dollar (US perspective).
currency (US perspective). 0.97 euro =$1
1 Euro = $ 1.031
Reciprocal of Indirect quote Reciprocal of Direct quote
DQ= 1 /IQ = 1/.97= $ 1.031 IQ=1/DQ=1/1.031=.97
DQs are easier to link with comments about any
foreign currency
Direct and Indirect quotation for a given currency move in opposite direction over a particular period.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 5

 I. Cross Exchange Rates
• Exchange rates between currency A and currency B, given the value of currencies A and
B with respect to a third currency.
• Example:
Given Cross Exchange Rate

Peso is worth $.07 The value of Peso in C$?

C$ is worth $.70

Value of Peso in C$ = Value of Peso in $ = $.07 = C$ .10

Value of C$ in $ $.70
Thus one Mexican peso is worth C$ .10.

Similarly, the number of pesos equal to one C$ can be calculated by taking reciprocal i.e. .70
Value of C$ in Peso = Value of C$ in $ = $.70 = 10
Value of Peso in $ $.07
Thus one Canadian $ is worth 10.0 pesos.

B. FORWARD MARKET (TRANSACTIONS)

1. Forward Market for Currencies
• A market for trading foreign exchange contract initiated today but to be settled at a future
date
• Contracting today for the future purchase/sale of forward market
2. Forward Rate
• The rate at which a bank is willing to exchange one currency for another at some
specified date in the future.
• Forward price may be the same as the spot price, but it is higher (at a premium) or lower
(at a discount) than the spot price.
• MNCs commonly use the forward market to hedge future payments/receipts that expect
to make or receive in a foreign currency. They don’t have to worry about fluctuations in
the spot rate until time of their future payments.
• Forward Market Hedge:
A method of hedging exchange risk exposure in which a foreign currency contract is sold
or bought forward.

3. Quotations of Forward Rates

• Some quotations of exchange rate include forward rates for the most widely traded
currencies.
Eg: `The Wall Street Journal’ publishes Forward rate quotations for major currencies
for 1, 3 and 6 month maturities.
• Other forward rates are quoted by banks that offer forward countries in various
currencies.
• Forward quotes are either direct or indirect, one being the reciprocal of the other.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 6

 C. CURRENCY FUTURES AND OPTIONS MARKET
• Currency futures contracts specify a standard volume of a particular currency to be
exchanged on a specific settlement date. They are sold on exchanges, unlike forward
contracts.
• Currency call (put) options give the right to buy (sell) a specific currency at a specific price
(called the strike or exercise price) within a specific period of time.

INTERNATIONAL ARBITRAGE
• Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices to make a
risk less profit.
• The effect of arbitrage on demand and supply is to cause prices to realign, such that no further
risk-free profits can be made.

Types of International Arbitrage

As applied to foreign exchange and international money markets, arbitrage takes three common
forms:
¤ locational arbitrage
¤ triangular arbitrage
¤ covered interest arbitrage

A. Locational Arbitrage

Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s
selling price (ask price) for the same currency.
Example
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.

B. Triangular Arbitrage
• Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from
spot rate quotes.
Example Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
British pound (£) MYR8.10 MYR8.20
MYR8.10/£  $.200/MYR = $1.62/£
Buy £ @ $1.61, convert @ MYR8.10/£, then sell MYR @ $.200. Profit = $.01/£.
• When the actual and calculated cross exchange rates differ, triangular arbitrage will force them back
into equilibrium.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 7

 C. Covered Interest Arbitrage

Covered interest arbitrage is the process of capitalizing on the interest rate differential between two
countries while covering for exchange rate risk.
Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate
differentials.
Covered Interest Arbitrage
Example
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are earning interest at 2%. Convert $ to £ at $1.60/£ and
engage in a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%.
Note: Profits are not achieved instantaneously.

Comparing Arbitrage Strategies

• Locational Arbitrage: Capitalizes on discrepancies in exchange rates across locations.

Triangular Arbitrage: Capitalizes on discrepancies in cross exchange rates.
Covered Interest Arbitrage: Capitalizes on discrepancies between the forward rate and the interest rate
differential.
• Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy, thus making the
foreign exchange market more orderly.
SWIFT
(The Society for Worldwide Interbank Financial Telecommunication)
SWIFT allows international banks to communicate instructions. It is a private non-profit message transfer
system (HQ in Brussels) with international switching centers in the Netherlands & Virginia.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 8

 DISCUSSION PROBLEMS/CASES

1. Indiana Co. purchases supplies priced at 100,000 euros from Belgo, a Belgium Supplier, on the
first day of each month. Indiana instructs its bank to transfer funds from its a/c to the supplier’s
a/c. It only has dollars in its account, whereas Belgo’s a/c is in euros.
Last month, the euro was worth $1.08 where as it is currently valued at $ 1.12
Required
a. How much does the $ balance of Indiana Co are reduced?
b. How is the money sent to Belgo?
c. Narrate the role of bank in this case.
d. How can the bank manage if it experiences shortage in foreign currency?

Bid/Ask Spread of Banks

2. Stetson Bank quotes a bid rate of $ .784 to the Australian $ and an ask rate of $ .80. What is the
bid/ask percentage spread?
3. Fullerton Bank quotes an ask price of $ .190 for the Peruvian currency and a bid rate of $ .188.
Determine the bid/ask percentage spread.
4. Assume that you have $1,000 and plan to travel from the US to the UK. Assume further that the
bank’s bid rate for the British £ is $ 1.52 and its ask rate is $ 1.60
a. What is the bid/ask spread in percentage terms?
b. How much do you get if you convert your $ money?
c. Suppose that because of an emergency you cannot take the trip now much $ would you
get back?
d. What is the impact of bid/ask spread in this conversion?
5. Charlotte Bank quotes a bid price for Yen of $ 0.007 and an ask price of $ 0.0074. What is the
bid/ask spread? Assume that a traveler sells $ 1,000 for Yen, how much does the traveler get
back $ amount if he cancels his trip? What is the amount and percentage of loss?
Interpreting foreign exchange quotations
6. Direct and indirect exchange rates for two points in time are given below
Currency Direct Indirect Quotation Direct Quotation Indirect Quotation
Quotation as of (number of units as of End of (number of units per
Beginning of per dollar) as of Semester dollar) as of End of
Semester Beginning of Semester
Semester

Canadian $ $.66 1.51 $.70 1.43

Mexican $.12 8.33 $.11 9.09

Peso

a. How do the direct and indirect quotations for a given currency move?
b. Interpret the direct and indirect exchange rates of Canadian $ and Mexican Peso.

Cross Exchange Rate

7. If the peso is worth $ 0.07 and the Canadian $ is worth $ .70, what would be the value of the Peso
in Canadian Dollar?
8. Assume Poland’s currency (the zloty) is worth $ 1.17 and the Japanese yen is worth $ 0.008.
What is the cross rate of the zloty with respect to yen? That is, how many yen equal to zloty?
9. If the British Pound (£) is worth $ 1.60, while the Canadian dollar (C$) is worth $ .80, what is the
value of British Pound with respect to Canadian dollar?
Foreign Exchange
10. You just came back from Canada, where Canadian dollar was worth $.70. You still have C$200
from your trip and could exchange them for dollars at the airport, but the airport foreign
exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 9

 need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a
tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your
C$ 200 for 1,300 pesos.
Should you accept the offer or cash the Canadian dollars in at the airport? Explain.
International Financial Markets
11. Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a
population of 3.7 million. These outlets are massive and contain products purchased locally as
well as imports. As Wal-Mart is likely to build additional outlets in Shanzen, it may remit those
earnings back to United States. Wal-Mart is likely to build additional outlets in Shanzen or in
other Chinese cities in the future.
a. Explain how the Wal-Mart outlets in China would use the spot market in foreign
exchange.
b. Explain how Wal-Mart might utilize the international money markets when it is
establishing other Wal-Mart in stores in Asia.
c. Explain how Wal-Mart could use the international bond market to finance the
establishment of new outlets in foreign markets.
Arbitrage
12. Two coin-shops buy and sell coins. If shop A is willing to sell a particular coin for $ 120, while
shop B is willing to buy that same coin for $ 130
a. How can an arbitrage be executed?
b. When does this opportunity occur?
c. In what way does the act of arbitrage influence prices?

Locational Arbitrage
13. Akron Bank and Zyn Bank serve the foreign exchange markets by buying and selling currencies.
Assume that there is no bid/ask spread. The exchange rate quoted at Akron bank for a British £ is
$ 1.60, while the exchange rate quoted by Zyn Bank is 1.61.
a. How can the locational arbitrage be conducted?
b. What would be your gain by conducting this arbitrage strategy?
c. What is the nature of this gain?
d. Can other banks know this discrepancy between Akron Bank and Zyn Bank? If yes, how
do they know and what is the impact?

14. Akron Bank and Zyn Bank serve the foreign exchange markets by buying and selling currencies.
The bid/ask spread of currency quote for locational arbitrage are as follows:
Akron Bank Zyn Bank
Bid Ask Bid Ask
£ quote $1.60 $1.61 £ quote $1.61 $1.62
a. Is it worthwhile to buy pounds from Akron Bank and sell them to Zyn Bank?
b. When can the banks achieve profits from locational arbitrage?

Gains from Locational Arbitrage

15. The quotations for the New Zealand dollar (NZ$) at two banks are follows:

North Bank South Bank

Bid Ask Bid Ask

NZ$ quote $.635 $.640 NZ$ quote $.645 $.650

a. Is there a scope for locational arbitrage?

b. If you start with $10,000 and conduct one round-trip transaction, how many US $ will you
end up with?
c. How does the round trip transaction take place?

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 10

 d. How long would you continue to repeat your round – trip transaction?
e. Is realignment possible? If yes, how does it happen?

Triangular Arbitrage

16. A bank has quoted the British Pound (£) at $ 1.60, the Malaysian ringgit (MYR) at $.20 and the
cross exchange rate at £ 1=MYR 8.1
a. How much should the £ worth be in MYR on the basis of cross exchange rate formula?
b. What does the quoted cross exchange rate (£ 1=MYR 8.1) imply?
c. How can you engage in triangular arbitrage?
d. If you have $ 10,000, how many dollars will you end up with if you implement triangular
arbitrage strategy?

17. Assume that the following spot exchange rates exist today:
£ 1 = $ 1.50
C$ = $ .75
£1 = C$ 2
Assume no transaction costs. Based on these exchange rates, can triangular arbitrage be used to
earn a profit? Explain.

Accounting for the Bid/Ask Spread in Triangular Arbitrage

18. The currency quote for a triangular arbitrage are as follows:

Quoted Bid Price Quoted Ask Price

Value of British pound in U.S. dollars $ 1.60 $ 1.61
Value of Malaysian ringgit (MYR) in U.S. dollars $ .200 $ .201
Value of British pound in Malaysian ringgit (MYR) MYR 8.10 MYR 8.20
If you have $ 10,000, how many dollars will you end up if you implement triangular arbitrage
strategy? Calculate the profit from triangular arbitrage.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 11

Covered Interest Arbitrage
19. Assume the following information:
The current spot rate of £ =$ 1.60
180-day forward rate of £ = $ 1.60
180-day British interest rate = 4%
180 day U.S interest rate = 2 %
Assume that you have $ 800,000 to invest.
Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that
US.S investors use their own funds)?
Determine the yield earned from covered interest arbitrage.
20. Assume that as a result of CIA, the market forces caused the spot rate of the £ to rise to $ 1.62
and that the 90-day forward rate of £ declined to $ 1.5888. Using $ 800,000 in CIA, determine
the yield there from.
21. Assume the following information:
Spot rate of £ =$ 1.60
180-day forward rate of £ = $ 1.56
180-day British interest rate = 4%
180 day U.S interest rate = 3 %
Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that
US investors use their own funds)? Explain.
22. The following exchange rates and one-year interest rates exist.
Bid Quote Ask Quote
Euro spot $1.12 $1.13
Euro one-year forward 1.12 1.13
Deposit Rate Loan Rate
Interest rate on dollars 6.0% 9.0%
Interest rate of euros 6.5% 9.5%
You have $ 100,000 to invest for one year. Would you benefit from engaging in covered interest
arbitrage?
Determining Exchange Rates

23. The annual changes in the value of euro are shown below:
Date Exchange Rate Annual percentage change
01/01/2000 $ 1.001 -
01/01/2001 $ .94 -6.1%
01/01/2002 $ .89 -5.3%
01/01/2003 $ 1.05 +18.0%
01/01/2004 $ 1.26 +20.0%
a. Assume that a hotel in Europe charged 100 euros for a room on these two dates:
01/01/2003 and 01/01/2004. What would have been your cost if you had visited Europe
and stayed in the hotel? What does it imply?
b. How much the Europeans who visited the US during this time would have paid for a
hotel.
c. If a US-based MNC purchased products priced at 1million euros at the beginning of 2003
and 2004, how much it would have paid?
d. How much an MNC based in Europe would have paid to buy dollar dominated products
worth 1 million?

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 12

 CASE ANALYSIS

I. Decision to Use International Financial Markets (Blades, Inc.)

1. One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand
and the delayed conversion of baht into dollars. Explain what this means.

ANSWER: If the net baht-denominated cash flows are converted into dollars today, Blades is not subject
to any future depreciation of the baht that would result in less dollar cash flows.

2. If the net baht received from the Thailand operation are invested in Thailand, how will U.S.
operations be affected? (Assume that Blades is currently paying 10 percent on dollars borrowed, and
needs more financing for its firm.)

ANSWER: If the cash flows generated in Thailand are all used to support U.S. operations, then Blades
will have to borrow additional funds in the U.S. (or the international money market) at an interest rate of
10 percent. For example, if the baht will depreciate by 10 percent over the next year, the Thai investment
will render a yield of roughly 5 percent, while the company pays 10 percent interest on funds borrowed in
the U.S. Since the funds could have been converted into dollars immediately and used in the U.S., the
baht should probably be converted into dollars today to forgo the additional (expected) interest expenses
that would be incurred from this action.

3. Construct a spreadsheet that compares the cash flows resulting from two plans. Under the first plan,
net baht-denominated cash flows (received today) will be invested in Thailand at 15 percent for a
one-year period, after which the baht will be converted to dollars. The expected spot rate for the baht
in one year is about $0.022 (Ben Holt’s plan). Under the second plan, net baht-denominated cash
flows are converted to dollars immediately and invested in the U.S. for one year at 8 percent. For this
question, assume that all baht-denominated cash flows are due today. Does Holt’s plan seem superior
in terms of dollar cash flows available after one year? Compare the choice of investing the funds
versus using the funds to provide needed financing to the firm.

ANSWER: (See spreadsheet attached.) If Blades can borrow funds at an interest rate below 8 percent, it
should invest the excess funds generated in Thailand at 8 percent and borrow funds at the lower interest
rate. If, however, Blades can borrow funds at an interest rate above 8 percent (as is currently the case with
an interest rate of 10 percent), Blades should use the excess funds generated in Thailand to support its
operations rather than borrowing.

Plan 1–Ben Holt's Plan

Calculation of baht-denominated revenue:
Price per pair of "Speedos" 4,594
× Pairs of "Speedos" 180,000
= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871
× Pairs of "Speedos" 72,000
= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows now (826,920,000 – 206,712,000) 620,208,000
Interest earned on baht over a one-year period (15%) 93,031,200
Baht to be converted in one year 713,239,200
× Expected spot rate of baht in one year $ 0.022

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 13

 = Expected dollar receipts in one year $ 15,691,262

Plan 2—Immediate Conversion

Calculation of baht-denominated revenue:
Price per pair of "Speedos" 4,594
× Pairs of "Speedos" 180,000
= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871
× Pairs of "Speedos" 72,000
= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows to be converted (826,920,000 – 206,712,000) 620,208,000
× Spot rate of baht now $ 0.024
= Dollar receipts now $ 14,884,992
Interest earned on dollars over a one-year period (8%) 1,190,799
= Dollar receipts in one year $ 16,075,791

Calculation of dollar difference between the two plans:

Plan 1 $ 15,691,262
Plan 2 16,075,791
Dollar difference $ (384,529)

Thus, the cash flow generated in one year by Plan 1 exceed those generated by Plan 2 by approximately
$384,529. Therefore, Ben Holt's plan should not be implemented.
Case1: Decisions to Use International Financial Markets

Question No 3.
If Blades can borrow funds at an interest rate below 8 percent, it should invest the excess funds generated
in Thailand at 8 percent and borrow funds at the lower interest rate. If, however, Blades can borrow funds
at an interest rate above 8 percent (as is currently the case with an interest rate of 10 percent), Blades
should use the excess funds generated in Thailand to support its operations rather than borrowing.
Plan 1–Ben Holt's Plan
Calculation of baht-denominated revenue:
Price per pair of "Speedos" 4,594
× Pairs of "Speedos" 180,000
= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871
× Pairs of "Speedos" 72,000
= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows now (826,920,000 – 206,712,000) 620,208,000
Interest earned on baht over a one-year period (15%) 93,031,200
Baht to be converted in one year 713,239,200
× Expected spot rate of baht in one year $ 0.022
= Expected dollar receipts in one year $ 15,691,262

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 14

Plan 2—Immediate Conversion
Calculation of baht-denominated revenue:
Price per pair of "Speedos" 4,594
× Pairs of "Speedos" 180,000
= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871
× Pairs of "Speedos" 72,000
= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows to be converted (826,920,000 – 206,712,000) 620,208,000
× Spot rate of baht now $ 0.024
= Dollar receipts now $ 14,884,992
Interest earned on dollars over a one-year period (8%) 1,190,799
= Dollar receipts in one year $ 16,075,791

Calculation of dollar difference between the two plans:

Plan 1 $ 15,691,262
Plan 2 16,075,791
Dollar difference $ (384,529)

Thus, the cash flow generated in one year by Plan 1 exceed those generated by Plan 2 by approximately
$384,529. Therefore, Ben Holt's plan should not be implemented.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 15

Case 2: Assessment of Potential Arbitrage Opportunities
1. Locational arbitrage is possible:
Locational Arbitrage
1. Buy Thai baht from Minzu Bank ($100,000/$0.0227) 4,405,286.34
2. Sell Thai baht to Sobat Bank (THB4,405,286.34 × $0.0228) 100,440.53
3. Dollar profit ($100,440.53 – $100,000) 440.53

2. Triangular arbitrage is possible.

Triangular Arbitrage
1. Exchange dollars for Thai baht ($100,000/$0.0227) 4,405,286.34
2. Convert the Thai baht into Japanese yen (THB4,405,286.34 × ¥2.69) 11,850,220.25
3. Convert the Japanese yen into dollars (¥11,850,220.26 × $0.0085) 100,726.87
4. Dollar profit ($100,726.87 – $100,000) 726.87

3. Covered interest arbitrage is possible.

Covered Interest Arbitrage
1. On Day 1, convert U.S. dollars to Thai baht and set up a 90-day deposit
account at a Thai bank ($100,000/$0.0227) 4,405,286.34
2. In 90 days, the Thai deposit will mature to THB4,405,286.34 × 1.0375,
which is the amount to be sold forward 4,570,484.58
3. In 90 days, convert the Thai baht into U.S. dollars at the agreed-upon rate
(THB4,570,484.58 × $0.0225) 102,835.90
4. Dollar amount available on a 90-day U.S. deposit ($100,000 × 1.02) 102,000.00
5. Dollar profit over and above the dollar amount available on a 90-day U.S. 2,835.90
deposit ($102,835.90 – $100,000)

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 16

 Case 2: Assessment of Potential Arbitrage opportunities (Blades, Inc.)

1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate quotations
from two banks in Thailand, Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask
prices of Thai baht for each bank are displayed in the table below:

Minzu Bank Sobat Bank

Bid $0.0224 $0.0228
Ask $0.0227 $0.0229

Determine whether the foreign exchange quotations are appropriate. If they are
not appropriate, determine the profit you could generate by withdrawing
$100,000 from Blades’ checking account and engaging in arbitrage before the
rates are adjusted.
ANSWER: Locational arbitrage is possible:
Locational Arbitrage

1. Buy Thai baht from Minzu Bank ($100,000/$0.0227) 4,405,286.34

2. Sell Thai baht to Sobat Bank (THB4,405,286.34 × $0.0228) 100,440.53

3. Dollar profit ($100,440.53 – $100,000) 440.53

2. Besides the bid and ask quotes for the Thai baht provided in the previous question, Minzu Bank has
provided the following quotations for the U.S. dollar and the Japanese yen:

Quoted Bid Price Quoted Ask Price

Value of a Japanese yen in U.S. dollars $0.0085 $0.0086
Value of a Thai baht in Japanese yen ¥2.69 ¥2.70

Determine whether the cross exchange rate between the Thai baht and Japanese yen is appropriate. If
it is not appropriate, determine the profit you could generate for Blades Inc, by withdrawing $100,000
from Blades’ checking account and engaging in triangular arbitrage before the rates are adjusted.

ANSWER: Triangular arbitrage is possible.

Triangular Arbitrage

1. Exchange dollars for Thai baht ($100,000/$0.0227) 4,405,286.34

2. Convert the Thai baht into Japanese yen (THB4,405,286.34 × ¥2.69) 11,850,220.25

3. Convert the Japanese yen into dollars (¥11,850,220.26 × $0.0085) 100,726.87

4. Dollar profit ($100,726.87 – $100,000) 726.87

3. Ben Holt has obtained several forward contract quotations for the Thai baht to determine whether
covered interest arbitrage may be possible. He was quoted a forward rate of $0.0225 per Thai baht for
a 90-day forward contract. The current spot rate is $0.0227. Ninety-day interest rates available to
Blades in the U.S. are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates
are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 17

 arbitrage, requires an investment of funds. Thus, he would like to be able to estimate the dollar profit
resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit.

Determine whether the forward rate is priced appropriately. If it is not priced appropriately, determine
the profit you could generate for Blades by withdrawing $100,000 from Blades’ checking account and
engaging in covered interest arbitrage. Measure the profit as the excess amount above what you could
generate by investing in the U.S. money market.

ANSWER: Covered interest arbitrage is possible.

Covered Interest Arbitrage

1. On Day 1, convert U.S. dollars to Thai baht and set up a 90-day deposit
account at a Thai bank ($100,000/$0.0227) 4,405,286.34

2. In 90 days, the Thai deposit will mature to THB4,405,286.34 × 1.0375,

which is the amount to be sold forward 4,570,484.58

3. In 90 days, convert the Thai baht into U.S. dollars at the agreed-upon rate
(THB4,570,484.58 × $0.0225) 102,835.90

4. Dollar amount available on a 90-day U.S. deposit ($100,000 × 1.02) 102,000.00

5. Dollar profit over and above the dollar amount available on a 90-day U.S. 2,835.90
deposit ($102,835.90 – $100,000)

4. Why are arbitrage opportunities likely to disappear soon after they have been discovered? To
illustrate your answer, assume that covered interest arbitrage involving the immediate purchase and
forward sale of baht is possible. Discuss how the baht’s spot and forward rates would adjust until
covered interest arbitrage is no longer possible. What is the resulting equilibrium state called?

ANSWER: Arbitrage opportunities are likely to disappear soon after they have been discovered
because of market forces. Due to the actions taken by arbitrageurs, supply and demand for the foreign
currency adjust until the mispricing disappears. For example, covered interest arbitrage involving the
immediate purchase and subsequent sale of Thai baht would place upward pressure on the spot rate of
the Thai baht and downward pressure on the Thai baht forward rate until covered interest arbitrage is
no longer possible. At that point, interest rate parity exists, and the interest rate differential between
the two countries is exactly offset by the forward premium or discount.

SIT-MBA INTERNATIONAL FINANCIAL MANAGEMENT Page | 18