International Trade Finance Slides

INTERNATIONAL TRADE FINANCE
Abubakar Musah
1
Multinational Financial Management – an overview
Introduction
Goal of an MNC and its conflicts
Theories of international Business
International Business Methods
Exposure to international risk
Overview of an MNC’s Cash Flows
MNC Valuation 2
Introduction
Firms continually devise strategies to improve cash flow necessary
to enhance shareholder wealth
What are these strategies? Some strategies involve penetrating
foreign markets
Foreign markets:
 Distinctly different from local market
 Offer opportunities for improving cash flows
 Recently barriers of entering foreign markets removed
 This has encouraged international business
 Many firms have therefore evolved into MNCs 3
Introduction
Initially, firms may engage in international business merely
through the export and import of products and/ or supplies
Over time as they recognize additional foreign

opportunities they eventually establish subsidiaries in
foreign countries.
MNCs such as Colgate-Palmolive, Coca-Cola, ExxonMobil

generate more than 50% of their sales from outside
countries. 4
Introduction
Understanding of International Financial Management
crucial
 Not only to the large MNC
 But also to small firms conducting international business
It is equally important to companies with no international

business
5
Introduction
Important to companies with no international business
because these companies must recognize how their foreign
competitors are affected by
 Movements in exchange rates
 Foreign interest rates
 Labour costs
 Inflation, etc.
Such economic characteristics can affect the foreign

competitors’ costs of production and pricing policies 6
Introduction
Companies must also recognize how domestic competitors
that obtain foreign supplies or foreign financing will be
affected by economic conditions in foreign countries
Domestic competitors may reduce their costs by

capitalizing on opportunities in international markets
7
Multinational Corporation (MNC) - Defined
For the purposes of this course, we refer to a Multinational
Corporation as one controlled by one headquarters but
operations spread over many countries.
Firm that engage in some form of international business.
Their managers conduct international financial

management, which involves international investing and
financing decisions that are intended to maximize the value
of the MNC 8
Goal of the MNC
The commonly accepted goal of an MNC is to maximize
shareholder wealth.
Note that some MNCs may want to satisfy the goals of their
 Governments
 Banks
 Employees
9
Goal of the MNC
Agency Problems
The conflict of goals between managers and shareholders
Agency Costs
Cost of ensuring that managers maximize shareholder wealth.
Costs are normally higher for MNCs than for purely domestic firms for
several reasons:
1) Monitoring managers of distant subsidiaries in foreign countries is
more difficult.
2) Foreign subsidiary managers raised in different cultures may not
follow uniform goals.
3) Sheer size of larger MNCs can create large agency problems 10
Constraints Interfering with the MNC’s Goal
MNC managers attempt to maximize their firm’s value,
subject to various constraints:
 Environmental constraints.
 Regulatory constraints.
 Ethical constraints.
11
Environmental constraints.
 building codes
 disposal of waste materials
 pollution controls etc.
Regulatory constraints.
 Taxes
 Currency convertibility rules
 Earnings remittance restrictions
12
Ethical constraints:
 No consensus standard of business conduct applies to all
countries
 What is ethical in one country may be unethical or illegal in
another country
 The dilemma faced by companies is if they do not practice that,
they may be at a competitive disadvantage.
13
Theories of International Business
The commonly held theories as to why firms become
motivated to expand their business internationally include
 The theory of comparative advantage
 The imperfect markets theory
 The product cycle theory
14
International Business Methods
Common methods used by firms to conduct international
business include:
 International trade
 Licensing
 Franchising
 Joint ventures
 Acquisitions of existing operations
 Establishing new foreign subsidiaries
15
Additional International Business Methods
 Management Contracts
 Turnkey projects
 Strategic Alliance
 Contract Manufacturing
16
International trade is a relatively conservative approach
involving exporting and/or importing.
Advantages of exporting
 Capital requirements and start-up costs minimal
 Risk is low
 Profits are immediate
 Initial step provides the opportunity to learn about present and future
supply and demand conditions, competition, channels of distribution,
payment conventions, financial institutions and financial techniques.
 If firm experiences decline in exporting or importing, it can
discontinue this part of its business at low cost 17
Licensing allows a firm to provide its technology
(copyrights, patents, trademarks, etc.)in exchange for fees
or some other benefits.
Advantages
 Minimal investment
 Faster market-entry time
 Fewer financial and legal risks involved
Disadvantages
 Cash flow relatively low
 There may be problems in maintaining product quality standards
 There may be difficulty controlling exports by the foreign 18
licensee
Franchising obligates a firm to provide a specialized sales
or service strategy, support assistance, and possibly an
initial investment in the franchise in exchange for periodic
fees.
Examples include: Smoothie Factory, Eazi-Sites,

Wayback Burgers, McDonalds, Pizza Hut, Blockbuster
Videos, Minuteman Press, KFC, etc.
19
Firms may also penetrate foreign markets by engaging in a
joint venture (joint ownership and operation) with firms that
reside in those markets. E.g. Spacefon – Areeba joint
venture
Acquisitions of existing operations in foreign countries

allow firms to quickly gain control over foreign operations
as well as a share of the foreign market. Vodafone – Ghana
Telecom Acquisition
20
Firms can also penetrate foreign markets by establishing
new foreign subsidiaries. E.g. Glo Mobile
In general, any method of conducting business that requires

a direct investment in foreign operations is referred to as a
direct foreign investment (DFI).
The optimal international business method may depend on

the characteristics of the MNC. 21
Degree of International Business by MNCs
Foreign Sales as a % of Total Sales
Foreign Assets as a % of Total Assets
70% 66%
62% 58%
60% 50%
46% 47%
50% 40%
40% 33%
30% 26%
20% 12%
10%
0%
Campbell's Dow IBM Motorola Nike
Soup Chemical 22
Exposure to International Risk
International business usually increases an MNC’s exposure to:
exchange rate movements
– Exchange rate fluctuations affect cash flows and foreign demand.
foreign economic conditions

– Economic conditions affect demand.
political risk
– Political actions affect cash flows.
23
Managing for Value
Like domestic projects, foreign projects involve an
investment decision and a financing decision.
When managers make multinational finance decisions that

maximize the overall present value of future cash flows,
they maximize the firm’s value, and hence shareholder
wealth.
24
Valuation Model for an MNC
Domestic Model
E (CF¢, t ) = expected cash flows to be received at

the end of period t
n = the number of periods into the future
in which cash flows are received
k = the required rate of return by
investors 25
Valuing International Cash Flows
m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows denominated in currency j
to be received by the parent company at the end
of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to parent currency at the end of
period t
k = the weighted average cost of capital of the parent 26
company
Example:
Adjoa Company Ltd has expected cash
flows of Gh¢100,000 from local business
and 1 million Naira from business in Nigeria
at the end of period t. Assuming the value
of a Naira is Gh¢0.014, what will be the
expected Cedi Cash flows of the company?
27
An MNC’s financial decisions include:
 how much business to conduct in each country and
 how much financing to obtain in each currency.
Its financial decisions determine its exposure to the

international environment.
28
Impact of New International Opportunities
on an MNC’s Value
Exposure to
Foreign Economies Exchange Rate Risk
m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 
Political Risk
29
THANK YOU
30
International Flow of Funds
Objectives
❖Explain the key components of the balance of payments.

❖Explain the growth in international trade activity over time.
❖Explain how international trade flows are influenced by economic
and other factors.
❖Explain how international capital flows are influenced by country
characteristics.
❖Introduce the agencies that facilitate the international flow of
funds.
Balance of Payments (1 of 6)
Definition:
Summary of transactions between domestic and
foreign residents for a specific country over a
specified period of time.
It accounts for transactions by businesses,

individuals, and the government.
Components of the Balance of Payments Statement:
❖ Current Account: summary of flow of funds due to
purchases of goods or services or the provision of income
on financial assets.
❖ Capital Account: summary of flow of funds resulting from

the sale of assets between one specified country and all
other countries over a specified period of time.
❖ Financial Account: refers to special types of investment,

including DFI and portfolio investment.
Current Account
❖ Payments for Goods and Services
o Merchandise exports and imports represent tangible products that
are transported between countries.
o Service exports and imports represent tourism and other services.
o The difference between total exports and imports is referred to as
the balance of trade.
❖ Factor Income Payments
❖ Represents income (interest and dividend payments) received by
investors on foreign investments in financial assets (securities).
❖ Transfer Payments
o Represents aid, grants, and gifts from one country to another.
Capital Account
❖Originally included the financial account.
❖Includes the value of financial assets transferred

across country borders by people who move to a
different country.
❖Includes patents and trademarks.
❖Relatively minor to financial account.

Financial Account
❖ Direct foreign investment
o Investments in fixed assets in foreign countries.
❖ Portfolio investment
o Transactions involving long term financial assets (such as stocks and
bonds) between countries that do not affect the transfer of control.
❖ Other capital investment
o Transactions involving short-term financial assets (such as money
market securities) between countries.
❖ Errors and omissions and reserves
o Measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country.
Growth in International Trade (1 of 6)
Events That Increased Trade Volume
❖Removal of the Berlin Wall (1989): Led to reductions in trade
barriers in Eastern Europe.
❖Single European Act of 1987: Improved access to supplies from
firms in other European countries.
❖North American Free Trade Agreement (NAFTA) – 1993 : Allowed
U.S. firms to penetrate product and labor markets that previously had
not been accessible. i.e. Mexico.
❖General Agreement on Tariffs and Trade (GATT): Called for the
reduction or elimination of trade restrictions on specified imported
goods over a 10-year period across 117 countries.
Events That Increased Trade Volume (cont.)
❖ The European Union: Free movement of products, services,
and capital among member countries.
❖ Inception of Euro (1999): Avoid exposure to exchange rate
risk.
❖ Assignment: Examine the impact of BREXIT on international
trade
❖ EU-ECOWAS EPA (2017): Enhanced trade among countries in EU
and ECOWAS.
Impact of Outsourcing on Trade
❖Definition of Outsourcing: The process of subcontracting to a third
party in another country to provide supplies or services that were
previously produced internally.
❖Impact of outsourcing:
o Increased international trade activity because MNCs now
purchase products or services from another country.
o Lower cost of operations and job creation in countries with low
wages.
❖Criticism of outsourcing:
❖Outsourcing may reduce jobs in the home country
Factors Affecting International Trade Flows (1 of 9)
Cost of Labor: Firms in countries where labor costs are low commonly
have an advantage when competing globally, especially in labor
intensive industries
Inflation: Current account decreases if inflation increases relative to

trade partners.
National Income: Current account decreases if national income

increases relative to other countries.
Credit Conditions: Tend to tighten when economic conditions weaken,

causing banks to be less willing to extend financing to MNCs
Government Policies:
❖ Restrictions on imports
❖ Subsidies for exporters
❖ Restrictions on piracy
❖ Environmental restrictions
❖ Labor laws
❖ Business laws
❖ Tax breaks
❖ Country trade requirements
❖ Government ownership or subsidies
❖ Country security laws
❖ Policies to punish country governments
Impact of Government Policies (cont.)
❖ Restrictions on Imports: Taxes (tariffs) on imported goods increase
prices and limit consumption. Quotas limit the volume of imports.
❖ Subsidies for Exporters: Government subsidies help firms produce
at a lower cost than their global competitors.
❖ Restrictions on Piracy: A government can affect international trade
flows by its lack of restrictions on piracy.
❖ Environmental Restrictions: Environmental restrictions impose
higher costs on local firms, placing them at a global disadvantage
compared to firms in other countries that are not subject to the same
restrictions.
❖ Labor Laws: Countries with more restrictive laws will incur higher
expenses for labor, other factors being equal.
❖ Business Laws: Firms in countries with more restrictive bribery laws

may not be able to compete globally in some situations.
❖ Tax Breaks: Though not necessarily a subsidy, still a form of

government financial support that might benefit many firms that
export products.
❖Country Trade Requirements: Requiring various forms or obtaining

licenses before countries can export to the country (Bureaucracy) is a
strong trade barrier.
❖Government Ownership or Subsidies: Some governments maintain
ownership in firms that are major exporters.
❖Country Security Laws: Governments may impose certain

restrictions when national security is a concern, which can affect trade.
❖Policies to Punish Country Governments: Many expect countries to

restrict imports from countries that:
❖ Fail to enforce environmental laws and child labor laws.
❖ Initiate war against another country.
❖ Are unwilling to participate in a war.
❖Summary of Government Policies:
o Every government implements some policies.
o No formula ensures a completely fair contest for market share.
Exchange Rates: Current account decreases if currency
appreciates relative to other currencies.
❖How exchange rates may correct a balance of trade deficit:

❖When a home currency is exchanged for a foreign currency to buy
foreign goods, then the home currency faces downward pressure,
leading to increased foreign demand for the country’s products.
❖Why exchange rates may not correct a balance of trade deficit:

❖Exchange rates will not automatically correct any international
trade balances when other forces are at work.
Exchange Rates (cont.)
❖ Limitations of a Weak Home Currency Solution
o Competition: Foreign companies may lower their prices to remain competitive.
o Impact of other currencies: A country that has balance of trade deficit with
many countries is not likely to solve all deficits simultaneously.
o Prearranged international trade transactions: International transactions cannot

be adjusted immediately. The lag is estimated to be 18 months or longer,
leading to a J-curve effect.
o Intracompany trade: Many firms purchase products that are produced by their
subsidiaries. These transactions are not necessarily affected by currency
fluctuations.
Exchange Rates (cont.)
❖ Exchange Rates and International Friction
o All governments cannot weaken their home currencies
simultaneously.
o Actions by one government to weaken its currency causes

another country’s currency to strengthen.
o Government attempts to influence exchange rates can

lead to international disputes.
International Capital Flows (1 of 4)
Factors Affecting Direct Foreign Investment
❖Changes in Restrictions
o New opportunities have arisen from the removal of government
barriers.
❖Privatization
❖DFI is stimulated by new business opportunities associated with
privatization.
❖Managers of privately owned businesses are motivated to ensure

profitability, further stimulating DFI.
Factors Affecting Direct Foreign Investment (Cont.)
❖Potential Economic Growth
o Countries with greater potential for economic growth are more likely to attract
DFI.
❖Tax Rates
o Countries that impose relatively low tax rates on corporate earnings are more
likely to attract DFI.
❖Exchange Rates
o Firms typically prefer to pursue DFI in countries where the local currency is
expected to strengthen against their own.
Factors Affecting International Portfolio Investment
❖ Tax Rates on Interest or Dividends
o Investors normally prefer to invest in a country where taxes are
relatively low.
❖ Interest Rates
o Money tends to flow to countries with high interest rates, as long
as the local currencies are not expected to weaken.
❖ Exchange Rates
o Investors are attracted to a currency that is expected to
strengthen.
Agencies that Facilitate International Flows (1 of 7)
1) International Monetary Fund
2) World Bank — (International Bank for Reconstruction and
Development)
3) World Trade Organization (WTO)
4) International Finance Corporation (IFC)
5) International Development Association (IDA)
6) Bank for International Settlements (BIS)
7) OECD — Organization for Economic Cooperation and Development
8) Regional Development Agencies
• Inter-American Development Bank
• Asian Development Bank
• African Development Bank
• European Bank for Reconstruction and Development
SUMMARY (1 of 4)
❖The key components of the balance of payments are the
current account and the capital account.
❖The current account is a broad measure of the country’s

international trade balance.
❖The capital account measures the value of financial and

nonfinancial assets transferred across country borders.
❖The financial account consists mainly of payments for direct

foreign investment and investment in securities (portfolio
investment).
SUMMARY (2 of 4)
❖International trade activity has grown over time in response to
several government agreements to remove cross-border
restrictions.
❖In addition, MNCs have commonly used outsourcing in recent

years, subcontracting with a third party in a foreign country
for supplies or services they previously produced themselves.
❖Thus, outsourcing is another reason for the increase in

international trade activity.
SUMMARY (3 of 4)
❖ A country’s international trade flows are affected by inflation,
national income, government restrictions, and exchange
rates.
❖ High labor costs, high inflation, a high national income, low

or no restrictions on imports, and a strong local currency
tend to result in a strong demand for imports and a current
account deficit.
❖ Although some countries attempt to correct current account

deficits by reducing the value of their currencies, this
strategy is not always successful.
SUMMARY (4 of 4)
❖ A country’s international capital flows are affected by any factors
that influence direct foreign investment or portfolio investment. DFI
tends to occur in those countries that have no restrictions and much
potential for economic growth. Portfolio investment tends to occur in
those countries where taxes are not excessive, where interest rates
are high, and where the local currencies are not expected to
weaken.
❖ Several agencies facilitate the international flow of funds by

promoting international trade and finance, providing loans to
enhance global economic development, settling trade disputes
between countries, and promoting global business relationships
between countries.
Discussion Questions
1. Is a current account deficit something to worry about? If a
government wants to correct a current account deficit, why can’t it
simply enforce restrictions on imports?
2. Should Trade Restrictions be Used to Influence Human Rights

Issues?
3. There has been considerable momentum to reduce or remove

trade barriers in an effort to achieve “free trade.” Yet, one
disgruntled executive of an exporting firm stated, “Free trade is not
conceivable; we are always at the mercy of the exchange rate. Any
country can use this mechanism to impose trade barriers.” What
does this statement mean?
4. When South Korea’s export growth stalled, some South Korean
firms suggested that South Korea’s primary export problem was the
weakness in the Japanese yen. How would you interpret this
statement?
THANK YOU
International Trade Finance
International Financial Markets
Describe the background and corporate use of the
following International Financial Markets:
▪ Foreign exchange market
▪ International money market
▪ International credit market
▪ International bond market
▪ International stock markets

Foreign Exchange Market (1 of 14)
✓ Allows for the exchange of one currency for another.
✓ Large commercial banks serve this market by holding inventories of

each currency so that they can accommodate requests by individuals
or MNCs.
✓ Individuals rely on the foreign exchange market when they travel to

foreign countries.
✓ Exchange rate specifies the rate at which one currency can be

exchanged for another.
✓ It is the rate at which one currency can be converted to another. It is

the price of one currency in terms of the other
History of Foreign Exchange
✓Gold Standard (1876 - 1913)
▪ Each currency was convertible into gold at a specified rate. When
World War I began in 1914, the gold standard was suspended.
✓Agreements on Fixed Exchange Rates

▪ Bretton Woods Agreement 1944 – 1971 (fixed rate, +/-1%)
▪ Smithsonian Agreement 1971 – 1973 (fixed rate, +/-2.25%)
✓Floating Exchange Rate System (1973)

▪ Widely traded currencies were allowed to fluctuate in accordance
with market forces
Foreign Exchange Transactions
✓ The over-the-counter market is the telecommunications (SWIFT)
network where companies normally exchange one currency for
another.
✓ Foreign exchange dealers serve as intermediaries in the foreign

exchange market
✓ Spot Market: A foreign exchange transaction for immediate exchange

is said to trade in the spot market. The exchange rate in the spot
market is the spot rate.
✓ Spot Market Structure: Trading between banks occurs in the interbank

market.
Foreign Exchange Transactions (cont.)
✓ Use of the dollar in spot markets: The U.S. Dollar is the commonly
accepted medium of exchange in the spot market. This is especially
true in countries where the home currency is weak or subject to
restrictions.
✓ Spot market time zones: Foreign exchange trading is conducted

only during normal business hours in a given location. Thus, at any
given time on a weekday, somewhere around the world a bank is
open and ready to accommodate foreign exchange requests.
✓ Spot market liquidity: More buyers and sellers means more liquidity.
Foreign Exchange Transactions (cont.)
✓ Attributes of Banks That Provide Foreign Exchange
▪ Competitiveness of quote
▪ Special relationship with the bank
▪ Speed of execution
▪ Advice about current market conditions
▪ Forecasting advice
Foreign Exchange Quotations
✓ At any given point in time, a bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.
✓ Bid/Ask spread of banks: The bid/ask spread covers the bank’s

cost of conducting foreign exchange transactions.
✓ Comparison of Bid/Ask spread among currencies

(Exhibit 3.1)
𝐴𝑠𝑘 𝑟𝑎𝑡𝑒 − 𝐵𝑖𝑑 𝑟𝑎𝑡𝑒
𝐵𝑖𝑑/𝐴𝑠𝑘 Spread =
𝐴𝑠𝑘 𝑟𝑎𝑡𝑒
Exhibit 3.1 Computation of the Bid Ask Spread
Foreign Exchange Quotations (cont.)
✓ Factors That Affect the Spread
▪ Order costs: Costs of processing orders, including clearing costs
and the costs of recording transactions.
▪ Inventory costs: Costs of maintaining an inventory of a particular
currency.
▪ Competition: The more intense the competition, the smaller the
spread quoted by intermediaries.
▪ Volume: Currencies that have a large trading volume are more liquid
because there are numerous buyers and sellers at any given time.
▪ Currency risk: Economic or political conditions that cause the
demand for and supply of the currency to change abruptly.
Interpreting Foreign Exchange Quotations
✓ Direct versus indirect quotations at one point in time
(Exhibit 3.2)
▪ Direct Quotation represents the value of a foreign currency in
terms of a local currency (number of Cedis per US Dollar).
• Example: US1$ = GH¢5.83 or GH¢5.83/ US $
▪ Indirect quotation represents the value of a local currency in

terms of foreign currency (Number of US Dollars per Cedi)
• Example: $ 0.17 per Cedi; GH¢ 1 = $ 0.17
• Indirect quotation = 1 / Direct quotation
Exhibit 3.2 Direct and Indirect Exchange Rate Quotations
Foreign Currency Direct Quotation Indirect quotation

US $ GHC5.83/US$ US$0.17/GHC
Currency
Interpreting Foreign Exchange Quotations (cont.)
✓ Direct versus indirect exchange rate over time
(Exhibit 3.3)
▪ When the euro is appreciating against the dollar (based on
an upward movement of the direct exchange rate of the
euro), the indirect exchange rate of the euro is declining.
▪ When the euro is depreciating (based on a downward

movement of the direct exchange rate) against the dollar,
the indirect exchange rate is rising.
✓ Source of exchange rate quotations
▪ Updated currency quotations are provided for several major
currencies on Yahoo’s website
(finance.yahoo.com/currency).
▪ Exchange rate quotations are also provided by many other

online sources, including oanda.com.
▪ There are apps available on the Play Store as well as App

Store for download
✓ Cross exchange rate: The calculation of foreign exchange rate from
two separate quotes that contain a common currency.
▪ Example
Value of peso = $0.11
Value of Canadian dollar = $0.70
Value of peso in C$ = Value of peso in $
Value of C$ in $
= $0.11 = C$ 0.157
$0.70
▪ Source of cross exchange rate quotations: Cross exchange rates
are provided for several major currencies on Yahoo’s website
(finance.yahoo.com/currency-converter).
✓ Currency Derivatives: A contract with a price that is partially
derived from the value of the underlying currency that it represents.
✓ Forward Contracts: agreements between a foreign exchange

dealer and an MNC that specifies the currencies to be exchanged,
the exchange rate, and the date at which the transaction will occur.
▪ The forward rate is the exchange rate specified by the forward

contract.
▪ The forward market is the over-the-counter market where

forward contracts are traded.
✓ Currency futures contracts: similar to forward
contracts but sold on an exchange.
▪ Specifies a standard volume of a particular currency to be
exchanged on a specific settlement date.
▪ The futures rate is the exchange rate at which one can
purchase or sell a specified currency on the specified
settlement date.
▪ The future spot rate is the spot rate that will exist at a
future point in time and is uncertain as of today.
✓ Currency Options Contracts
▪ Currency Call Option: provides the right to buy currency
at a specified strike price within a specified period of time.
▪ Currency Put Option: provides the right to sell currency at
specified strike price within a specified period of time.
International Money Market (1 of 5)
✓Corporations or governments need short-term funds
denominated in a currency different from their home
currency.
✓The international money market has grown because firms:

▪ May need to borrow funds to pay for imports
denominated in a foreign currency.
▪ May choose to borrow in a currency in which the interest
rate is lower.
▪ May choose to borrow in a currency that is expected to
depreciate against their home currency
Money Market Interest Rates Among Currencies
✓ The money market interest rates in any particular country are
dependent on the demand for short-term funds by borrowers,
relative to the supply of available short-term funds that are
provided by savers.
✓ Rates vary due to differences in the interaction of the total

supply of short-term funds available (bank deposits) in a
specific country versus the total demand for short-term funds
by borrowers in that country.
Money Market Interest Rates Among Currencies (cont.)
✓ Money market interest rates among countries tend to be
highly correlated over time.
✓ When economic conditions weaken, the corporate need for

liquidity declines, and corporations reduce the amount of
short-term funds they wish to borrow.
✓ When economic conditions strengthen, there is an

increase in corporate expansion, and corporations need
additional liquidity to support their expansion.
Money Market Interest Rates Among Currencies (cont.)
✓ Risk of International Money Market Securities
▪ International Money Market Securities are debt securities issued
by MNCs and government agencies with a short-term maturity (1
year or less).
▪ Normally, these securities are perceived to be very safe from the

risk of default.
▪ Even if the international money market securities are not exposed

to credit risk, they are exposed to exchange rate risk when the
currency denominating the securities differs from the home
currency of the investors.
✓Read on:
▪ European Money Market
▪ Asian Money Market
▪ African Money Market
International Credit Market (1 of 5)
✓ MNCs sometimes obtain medium-term funds through term loans
from local financial institutions or through the issuance of notes
(medium-term debt obligations) in their local markets.
✓ MNCs also have access to medium-term funds through banks
located in foreign markets
✓ Loans of 1 year or longer extended by banks to MNCs or
government agencies are commonly called Eurocredits or
Eurocredit loans.
✓ To avoid interest rate risk, banks commonly use floating rate
loans with rates tied to the London Interbank Offer Rate
(LIBOR).
Syndicated Loans in the Credit Market
✓ Sometimes a single bank is unwilling or unable to lend the

amount needed by an MNC or government agency.
✓ A syndicate of banks can be formed to underwrite the loans

and the lead bank is responsible for negotiating the terms
with the borrower.
✓ In 2016, COCOBOD signed up for a syndicated loan of about

US$1.8 billion financed by 24 banks abroad including Fidelity
Bank
Regulations in the Credit Market
✓ Single European Act
▪ Capital can flow freely throughout Europe.
▪ Banks can offer a wide variety of lending, leasing, and securities
activities in the EU.
▪ Regulations regarding competition, mergers, and taxes are similar
throughout the EU.
▪ A bank established in any one of the EU countries has the right to
expand into any or all of the other EU countries.
✓ Basel Accord — Banks must maintain a high level of capital as a
percent of their assets. For this purpose, banks’ assets are weighted
by risk.
Regulations in the Credit Market (Cont.)
✓ Basel II Accord — Attempts to account for differences in collateral
among banks. In addition, this accord encourages banks to improve
their techniques for controlling operational risk, which could reduce
failures in the banking system. Also plans to require banks to provide
more information to existing and prospective shareholders about their
exposure to different types of risk.
✓ Basel III Accord — Called for new methods of estimating risk-

weighted assets that would increase the level of risk-weighted assets,
and therefore require banks to maintain higher levels of capital.
Impact of the Credit Crisis on the Credit Market
✓ The credit crisis of 2008 triggered by defaults in subprime

loans led to a halt in housing development, which reduced
income, spending, and jobs.
✓ Financial institutions became cautious with their funds and

were less willing to lend funds to MNCs.
International Bond Market (1 of 3)
Foreign bonds are issued by borrowers foreign to the country where the
bond is placed.
Eurobonds
✓ Features of Eurobonds
▪ Bearer bonds
▪ Annual coupon payments
▪ Convertible or callable
✓ Denominations of Eurobonds
▪ Commonly denominated in a number of currencies
✓ Secondary Market
▪ Market makers are in many cases the same underwriters who sell the primary
issues
✓ Bond markets have developed in Asia and South America.
✓ Bond market yields among countries tend to be highly

correlated over time.
✓ When economic conditions weaken, aggregate demand

for funds declines with the decline in corporate expansion.
✓ When economic conditions strengthen, aggregate

demand for funds increases with the increase in corporate
expansion.
Risk of International Bonds
✓ Interest Rate Risk — potential for the value of bonds to decline in
response to rising long-term interest rates.
✓ Exchange Rate Risk — represents the potential for the value of
bonds to decline (from the investor’s perspective) because the
currency denominating the bond depreciates against the home
currency.
✓ Liquidity Risk — represents the potential for the value of bonds to
decline because there is not a consistently active market for the
bonds.
✓ Credit Risk — represents the potential for default.
International Stock Markets (1 of 3)
✓ Issuance of Stock in Foreign Markets — Some U.S. firms issue stock
in foreign markets to enhance their global image.
▪ Impact of the Euro: resulted in more stock offerings in Europe by
U.S. and European based MNCs.
✓ Many investors purchase stocks outside of the home country.

How Market Characteristics Vary among Countries
(Exhibit 3.6)
✓ Stock market participation and trading activity are higher in countries
where managers are encouraged to make decisions that serve
shareholder interests, and where there is greater transparency.
✓ Factors that influence trading activity:

▪ Rights vary by country
▪ Legal protection of shareholders
▪ Government enforcement of securities laws
▪ Accounting laws
Exhibit 3.6 Impact of Governance on Stock Market Participation and
Trading Activity
✓ Integration of Stock Markets
▪ Stock market conditions reflect the host country’s conditions. If
the country is integrated, the stock market will be also.
✓ Integration of International Stock Markets and Credit

Markets
▪ The key link is the risk premium, which affects the rate of return
required by financial institutions.
How Financial Markets Serve MNCs
Corporate functions that require foreign exchange
markets.
✓Foreign trade with business clients.
✓Direct foreign investment, or the acquisition of foreign real

assets.
✓Short-term investment or financing in foreign securities.
✓Longer-term financing in the international bond or stock

markets.
Summary (1 of 3)
✓The foreign exchange market allows currencies to be
exchanged in order to facilitate international trade or financial
transactions.
✓Commercial banks serve as financial intermediaries in this

market. They stand ready to exchange currencies for
immediate delivery in the spot market.
✓In addition, they are also willing to negotiate forward contracts

with MNCs that wish to buy and/or sell currencies in the future.
Summary (2 of 3)
✓ The international money markets are composed of several
large banks that accept deposits and provide short-term loans
in various currencies. This market is used primarily by
governments and large corporations (MNCs).
✓ The international credit markets are composed of the same

commercial banks that serve the international money market.
✓ These banks convert some of the deposits received into loans

(for medium-term periods) to governments and large
corporations.
Summary (3 of 3)
✓ The international bond markets facilitate international transfers of
long-term credit, thereby enabling governments and large
corporations to borrow funds from various countries.
✓ The international bond market is facilitated by multinational syndicates

of investment banks that help to place the bonds.
✓ International stock markets enable firms to obtain equity financing in

foreign countries.
✓ Thus, these markets help MNCs finance their international expansion.

1.Should Firms That Go Public Engage in
International Offerings?
2.Explain the foreign exchange situation for

countries that use the euro when they
engage in international trade among
themselves
INTERNATIONAL TRADE
FINANCE (BBAF 402)
ABUBAKAR MUSAH
Determination of Exchange Rate
Outline:
✓Introduction
✓Measuring exchange rate movements
✓Exchange rate determinations (equilibrium)
✓Factors Influencing exchange rate movements
✓Capitalizing on expected exchange rate movement
✓Carry Trade as a speculation strategy
Introduction
✓Financial managers of MNCs must, at all times, monitor exchange
rates since the value of their cash flows depend on them, to a large
extent.
✓They need to understand what factors determine exchange rates so

that they can predict how exchange rates may react to specific
factors.
✓This section will therefore discuss the key factors that cause
changes in the exchange rate between currencies
Measuring Exchange Rate Movement
✓Exchange rate movements affect an MNC’s value
▪ Inflows received from exporting
▪ Inflows received from a subsidiary
▪ Cash outflows needed to pay for imports.
✓Changes in economic conditions may lead to a decline or
an increase in a currency’s value.
✓A decline in a currency’s value is known as depreciation
whiles an increase in a currency’s value is known as
appreciation.
✓To determine whether a currency has appreciated or
depreciated in value, the percentage change in the exchange
rate is determined
𝑆𝑡 − 𝑆𝑡−1
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 =
𝑆𝑡−1
✓A positive percent change indicates that the currency has

appreciated. A negative percent change indicates that it has
depreciated.
Estimating percentage changes
Date Value of US % Change Value of Euro % change
Dollar
Jan 1 5.05 - 4.98 -
Feb 1 5.15 1.98% 4.96 -0.40%
Mar 1 5.60 8.74% 4.88 -1.61%
Apr 1 5.47 -2.32% 5.21 6.76%
May 1 5.49 0.37% 5.33 2.30%
Jun 1 5.52 0.55% 5.38 0.94%
Jul 1 5.57 0.91% 5.01 -6.88%
✓Exchange rate movements are more volatile over longer
periods of time.
✓If yearly exchange rate data are assessed then the

movements would be more volatile for each currency than
if we use daily exchange rates
✓You can try to calculate percentage changes of the US $

prices for the past 5 years and compare to that of the past 5
months
Equilibrium Exchange Rate
✓Although it is easy to measure the percentage change in a
currency’s value,
▪ it is more difficult to explain why the value changed or
▪ to forecast how it may change in the future
✓The exchange rate represents the price of a currency, or the

rate at which one currency can be exchanged for another.
✓Price of a currency (i.e. exchange rate) is determined by

the demand for that currency relative to its supply – market
forces
✓Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping demand
schedule
✓Changes in demand for foreign currency result partly from
international trade and international capital flows. If foreign
currency rates fall;
▪ Corporations will demand more foreign currency for importation
or international portfolio investments.
▪ Individuals would purchase more foreign goods since they
would be cheaper
Demand Schedule for US Dollars
Price of US $
Quantity of US $
✓Supply of a currency for sale increases when the value of
the currency increases, leading to an upward sloping supply
schedule
✓This can be viewed as the foreign demand for Cedis. For
instance if the Ghana Cedi is valued lower than the US $,
more foreigners will want to supply more US $ by
exchanging it for the Cedis in order to buy goods from
Ghana.
✓NB: All other factors remaining unchanged.
Supply of US Dollars
Price of US $
Quantity of US $
✓Equilibrium equates the quantity of Dollars demanded with
the supply of Dollars for sale.
✓At each exchange rate, there are corresponding demand for

and supply of the foreign currency.
✓If the demand is higher than the supply at a particular rate,

there will be shortage pushing the exchange rate upwards.
S
Price of US $
𝑿𝒆
Quantity of US $
Change in the Equilibrium Exchange Rate
✓Increase in demand: Banks will increase the exchange
rate to the level at which the amount demanded is equal to
the amount supplied in the foreign exchange market.
✓Decrease in demand: Banks will reduce the exchange rate

to the level at which the amount demanded is equal to the
amount supplied in the foreign exchange market.
Change in the Equilibrium Exchange Rate
✓Increase in supply: Banks will reduce the exchange rate
✓Decrease in supply: Banks will increase the exchange rate

Factors that influence Exchange Rates
✓The equilibrium exchange rate will change over time as
supply and demand schedules change.
𝑒 = 𝑓 ∆𝐼𝑁𝐹, ∆𝐼𝑁𝑇, ∆𝐼𝑁𝐶, ∆𝐺𝐶, ∆𝐸𝑋𝑃
∆INF = Change in inflation differentials between the two countries

∆INT = Change in interest rate differentials between the two countries
∆INC = Change in income differentials between the two countries
∆GC = Change in government controls in the two countries
∆EXP = Change in expectations of future exchange rates
✓Relative Inflation Rates: Increase in inflation in the local
country leads to increase in local demand for foreign goods,
an increase in local demand for foreign currency, and an
increase in the exchange rate for the foreign currency
✓Relative Interest Rates: Increase in local interest rates

leads to increase in demand for local deposits and a
decrease in demand for foreign deposits, leading to an
increase in demand for local currency and a decreased
exchange rate for the foreign currency
✓Relative Income Levels: Increase in local income leads to
an increase in local demand for foreign goods, an increased
demand for foreign currency relative to the local currency,
and an increase in the exchange rate for the foreign currency.
✓Government Controls via:
▪ Imposing foreign exchange barriers
▪ Imposing foreign trade barriers
▪ Intervening in foreign exchange markets
▪ Affecting macro variables such as inflation, interest rates, and
income levels
✓Expectations:
▪ Impact of favorable expectations: If investors expect interest rates
in one country to rise, they may invest in that country, leading to a
rise in the demand for foreign currency and an increase in the
exchange rate for foreign currency.
▪ Impact of unfavorable expectations: Speculators can place
downward pressure on a currency when they expect it to
depreciate.
▪ Impact of signals on currency speculation: Speculators may
overreact to signals, causing currency to be temporarily
overvalued or undervalued.
Capitalizing on Expected Exchange Rate Movements
✓When financial institutions believe that a currency is valued lower
than it should be in the foreign exchange market, they may invest in
that currency before it appreciates.
✓If financial institutions believe that a currency is valued higher than

it should be in the foreign exchange market, they may borrow funds
in that currency and convert it to their local currency now before the
currency’s value declines to its proper level.
✓There is speculation in foreign currencies even by individuals whose

careers have nothing to do with foreign exchange markets.
Carry Trade:
✓One of the most common strategies used by institutional and
individual investors to speculate in the foreign exchange market is the
carry trade
✓Investors attempt to capitalize on the difference in interest rates
between two countries by borrowing a currency with a low interest
rate and investing the funds in a currency with a high interest rate.
✓Before taking any speculative position in a foreign currency, carry
traders must consider the prevailing interest rates at which they can
invest or borrow in addition to their expectations about the movement
of exchange rates.
Illustration of Carry Trade
Hampton Investment Co. is a U.S. firm that executes a carry trade in
which it borrows euros (where interest rates are presently low) and
invests in British pounds (where interest rates are presently high).
Hampton uses $100,000 of its own funds and borrows an additional
600,000 euros. It will pay 0.5 percent on its euros borrowed for the
next month and will earn 1.0 percent on funds invested in British
pounds. Assume that the euro’s spot rate is $1.20 and that the British
pound’s spot rate is $1.80 (so the pound is worth 1.5 euros at this
time). Hampton uses today’s spot rate as its best guess of the spot rate
one month from now. Hampton’s expected profits from its carry trade
can be derived as follows.
At the beginning of Investment Period:
1) Hampton invests $100,000 of its own funds into British
pounds: $100,000/($1.80 per pound) = 55,555 pounds
2) Hampton borrows 600,000 euros and converts them into

British pounds: 600,000 euros/(1.5 euros per pound) =
400,000 pounds
3) Hampton’s total investment in pounds: 55,555 pounds +

400,000 pounds = 455,555 pounds
At the end of Investment Period:
1) Hampton receives: 455,555 (1.01) = 460,110 pounds
2) Hampton repays loan in euros: 600,000 euros (1.005) =

603,000 euros
3) Amount of pounds Hampton needs to repay loan in euros:

603,000 euros /(1.5 euros per pound) = 402,000 pounds
At the end of Investment Period:
4) Amount of pounds Hampton has after repaying loan:
460,110 pounds – 402,000 pounds = 58,110 pounds
5) Hampton converts pounds held into U.S. dollars: 58,110

pounds*$1.80 per pound = $104,598
6) Hampton’s profit: $104,598 – $100,000 = $4,598

✓The choice of the currencies to borrow and purchase is
influenced
▪ not only by prevailing interest rates
▪ but also by expected exchange rate movements.
✓Investors prefer to borrow a currency with a low interest rate

that they expect will weaken and to invest in a currency with
a high interest rate that they expect will strengthen.
✓Risk: Exchange rates may, however move opposite to what

the investors expected
International Trade Finance
(BBAF 402)
ABUBAKAR MUSAH
Government Influence on Exchange Rates
Outline:
✓Exchange Rate Systems
✓Development and Implications of Single

European Currency
✓Direct Government intervention
✓Indirect Government intervention

Exchange Rate Systems
✓Exchange rate systems can be classified
according to the degree of government control and
fall into the following categories:
▪Fixed exchange rate system
▪freely floating exchange rate system
▪Managed float exchange rate system
▪Pegged exchange rate system
Fixed Exchange Rate System
✓Exchange rates are either held constant or allowed
to fluctuate only within very narrow boundaries.
✓Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
✓Central bank can also revalue or increase the value
of its currency against other currencies.
✓Devaluation refers to a downward adjustment of the exchange
rate by the central bank
✓Depreciation refers to the decrease in a currency’s value that is

allowed to fluctuate in response to market conditions
✓Revaluation refers to an upward adjustment of the exchange rate

by the central bank
✓Appreciation refers to the increase in a currency’s value that is

allowed to fluctuate in response to market conditions.
✓Some fixed exchange agreements:
▪Bretton Woods Agreement 1944 – 1971 — Each
currency was valued in terms of gold.
▪Smithsonian Agreement 1971 – 1973 — called
for a devaluation of the U.S. dollar by about 8%
against other currencies
✓Some advantages of fixed exchange system:
▪Insulate country from risk of currency
appreciation.
▪Allow firms to engage in direct foreign
investment without currency risk.
▪Insulate portfolio investors from risk of foreign
currency depreciation over time
✓Some disadvantages of fixed exchange system:
▪Risk that government will alter value of currency.
▪Country and MNC may be more vulnerable to

economic conditions in other countries.
Freely Floating Exchange Rate System
✓Exchange rates are determined by market forces
without government intervention.
✓freely floating exchange rate system allows for

complete flexibility.
✓Adjusts on a continual basis in response to the

demand and supply conditions for that currency
✓Advantages of a freely floating system:
▪Country is more insulated from inflation of other
countries.
▪Country is more insulated from unemployment of

other countries.
▪Does not require central bank to maintain

exchange rates within specified boundaries.
✓Disadvantages of a freely floating exchange
rate system:
▪Can adversely affect a country that has high
unemployment.
▪Can adversely affect a country with high
inflation.
Countries with Floating Exchange Rates
Managed Float Exchange Rate System
✓Governments sometimes intervene to prevent their
currencies from moving too far in a certain direction.
✓Currencies of most large developed countries are allowed to
float, although they may be periodically managed by their
respective central banks
✓Criticisms of the managed float system:
▪ Critics suggest that managed float allows a government to
manipulate exchange rates to benefit its own country at the
expense of others.
Pegged Exchange Rate System
✓Home currency value is pegged to one foreign
currency or to an index of currencies.
✓Limitations of pegged exchange rate
▪May attract foreign investment because exchange rate is
expected to remain stable.
▪Weak economic or political conditions can cause firms
and investors to question whether the peg will be broken
✓Examples include:
▪Europe’s Snake Arrangement 1972 – 1979
▪European Monetary System (EMS) 1979 - 1992
▪Mexico’s Pegged System 1994
▪China’s Pegged Exchange Rate 1996 - 2005
▪Venezuela’s Pegged Exchange Rate 2010
✓Currency Boards Used to Peg Currency Values
▪ A system for pegging the value of the local currency to some other
specified currency. The board must maintain currency reserves for
all the currency that it has printed.
✓Interest Rates of Pegged Currencies
▪ Interest rate will move in tandem with the interest rate of the
currency to which it is tied.
✓Exchange Rate Risk of a Pegged Currency
▪ Provides examples of countries that have pegged the exchange rate
of their currency to a specific currency. Currencies are commonly
pegged to the U.S. dollar or to the euro.
Countries with pegged exchange rates
Dollarization
✓The replacement of a foreign currency with U.S. dollars.
✓This process is a step beyond a currency board because it
forces the local currency to be replaced by the U.S. dollar.
✓Although dollarization and a currency board both attempt to
peg the local currency’s value, the currency board does not
replace the local currency with dollars.
✓The decision to use U.S. dollars as the local currency
cannot be easily reversed because in that case the country no
longer has a local currency.
Government Intervention
Reasons for Government Intervention
✓Smoothing exchange rate movements
▪If a central bank is concerned that its economy will be
affected by abrupt movements in its home currency’s
value, it may attempt to smooth the currency movements
over time.
✓Establishing implicit exchange rate boundaries
▪Some central banks attempt to maintain their home
currency rates within some unofficial, or implicit,
boundaries.
Reasons for Government Intervention
✓Responding to temporary disturbances
▪ A central bank may intervene to insulate a currency’s value from
a temporary disturbance.
✓Several studies have found that government intervention

does not have a permanent effect on exchange rate
movements.
✓In the absence of intervention, however, currency

movements would be even more volatile.
Direct Intervention
✓To force the Cedi to depreciate, the CB can intervene
directly by exchanging Cedi that it holds as reserves for
other foreign currencies in the foreign exchange market.
✓By “flooding the market with Cedis” in this manner, the CB

puts downward pressure on the Cedi.
✓If the CB desires to strengthen the Cedi, it can exchange

foreign currencies for Cedis in the foreign exchange market,
thereby putting upward pressure on the Cedi.
Direct Intervention: Reliance on reserves
✓The potential effectiveness of a central bank’s direct
intervention is influenced by the amount of reserves it can
use.
✓India tried in 2012 to restore the value of the Rupee when it

lost 20% of value in the first half of the year.
✓However, the central bank’s efforts were ineffective

because market forces overwhelmed the direct intervention.
Direct Intervention: Frequency of intervention
✓As foreign exchange activity has grown, central bank
intervention has become less effective.
✓The volume of foreign exchange transactions on a single

day now exceeds the combined values of reserves at all
central banks.
✓Consequently, the number of direct interventions has

declined..
Direct Intervention: Coordinated Intervention
✓Intervention more likely to be effective when it is
coordinated by several central banks.
✓Coordinated intervention requires the central banks to agree

that a particular currency’s value needs to be adjusted.
Direct intervention: nonsterilized versus sterilized
✓When the CB intervenes in the foreign exchange market
without adjusting for the change in the money supply, it is
engaging in a nonsterilized intervention.
✓In a sterilized intervention, the CB intervenes in the foreign

exchange market and simultaneously engages in offsetting
transactions in the Treasury securities markets.
Direct intervention: speculating on direct intervention
✓Some traders in the foreign exchange market attempt to
determine when CB intervention is occurring and the extent
of the intervention in order to capitalize on the anticipated
results of the intervention effort.
✓CB may attempt to hide its strategy by pretending to be
interested in buying foreign, say US Dollars, when in fact, it
is interested in selling.
✓However, market participants usually get to know
Indirect intervention
✓The CB can affect the dollar’s value indirectly by
influencing the factors that determine it.
✓Government Control of Interest Rates by increasing or
reducing interest rates.
✓Government Use of Foreign Exchange Controls such as

restrictions on the exchange of the currency.
Indirect intervention
✓Intervention Warnings intended to warn speculators.
✓The announcements could discourage additional

speculation and might even encourage some speculators to
unwind (liquidate) their existing positions in the currency.
Intervention as a Policy Tool
✓Government may consider influencing the value of home
currency in order to improve local economy.
✓A weak home currency can stimulate foreign demand for

products.
✓A strong home currency can encourage consumers and

corporations of that country to buy goods from other
countries.
Assignment
1) Discuss the impact of a single European Currency:
a) on Eurozone Monetary Policy
b) on Firms in the Eurozone
c) on Financial Flows in the Eurozone
2) What is the impact of a country abandoning the Euro (Use

BREXIT as a case study)
THANK YOU
(BBAF 402)
ABUBAKAR MUSAH
International Arbitrage and Interest Rates Parity
✓Introduction
✓Locational arbitrage
✓Triangular Arbitrage
✓Covered Interest Arbitrage
✓Interest Rate Parity

Introduction
✓If discrepancies occur in the foreign exchange
market, with quoted prices of currencies varying from
what their market prices should be, then certain
market forces will realign the rates.
✓This realignment occurs as a result of international

arbitrage.
✓Need for FM of MNCs to understand how

international arbitrage realigns exchange rates.
Introduction
✓Arbitrage can be loosely defined as capitalizing on a
discrepancy in quoted prices by making a riskless
profit.
✓Often, the funds invested are not tied up and no risk

is involved.
✓In response to the imbalance in demand and supply

resulting from arbitrage activity, prices will realign
very quickly, such that no further risk-free profits can
be made.
Introduction
✓There are three forms of arbitrage
▪Locational Arbitrage
▪Triangular Arbitrage
▪Covered Interest Arbitrage
✓The scope of discussion on these types of arbitrage

is international.
✓It is applied to foreign exchange and international
money markets
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.
✓Arbitrageurs take advantage by buying a currency at
the location where it is priced cheap and immediately
selling it at another location where it is priced higher
✓The disparity in rates can occur since information is
not always immediately available to all banks
✓Gains from locational arbitrage are based on the
amount of money used and the size of the
discrepancy.
✓Realignment due to locational arbitrage drives

prices to adjust in different locations so as to
eliminate discrepancies
Example 1: Invest $100,000
CURRENCY NORTH BANK SOUTH BANK
BID ASK BID ASK
NZ $ $0.635 $0.640 $0.645 $0.650
Example 2: Invest GH¢100,000

CURRENCY PHARMA BANK KARMA BANK
BID ASK BID ASK
US $ GH¢5.15 GH¢5.34 GH¢5.40 GH¢5.50
Triangular Arbitrage
✓Is an arbitrage process involving three currencies that keeps
cross-rates (such as euros per British pound) in line with
dollar exchange rates
✓It is possible when a cross exchange rate quote differs from
the rate calculated from spot rates
✓Action to capitalize on a discrepancy where the quoted cross
exchange rate is not equal to the rate that should exist at
equilibrium
✓Assume the euro and the British pound are both quoted
versus the US dollar: €0.8408/$ and £0.5749/$.
✓The EURO/P0UND cross rate of €1.4625/£ is the third leg
of the triangle.
✓If one of the exchange rates changes due to market forces,
the others must adjust for the three exchange rates again to
align.
✓If they are out of alignment, it would be possible to make a
profit simply by exchanging one currency for a second, the
second for a third, and the third back to the first.
✓This is known as TRIANGULAR ARBITRAGE
✓A trader can conduct a triangular arbitrage in many ways.
✓For example, a trader might start by directly buying a

currency such as the pound with Euros and then
simultaneously selling the Pounds for dollars and selling the
dollars for Euros.
✓In other words, instead of exchanging just two currencies,

the trader exchanges three currencies simultaneously (hence
the term “triangular” arbitrage).
✓If the number of Euros the trader has at the end of these
three transactions is greater than the number of Euros at the
beginning, there is a profit.
✓An alternative approach would be to buy pounds indirectly

with Euros by first buying dollars and then buying pounds
and selling the pounds for euros.
✓ Once again, the trader would want to have more Euros at

the end than at the beginning.
✓In the expression below, the euro price of the pound is equal
to the euro price of the U.S. dollar multiplied by the U.S.
dollar price of the pound
(€/ £) = (€ /$) 𝑋 ($/ £)
✓There is no arbitrage since there is equality between the

quoted cross-rate and the cross-rate implied by two dollar
quotes:
✓In other words, the direct quote for the cross-rate should
equal the implied cross-rate, using the dollar as an
intermediary currency.
✓To see how a triangular arbitrage works, suppose that the
euro price of the pound quoted in the market is €1.4381/£.
✓Also, suppose that this quoted cross-rate is lower than the
indirect rate, using the dollar as the intermediary currency.
That is,
✓(Euros/Pound) < (Euros/Dollar) X (Dollars/Pound)
✓This means there is some room to make a profit.
✓In this situation, buying the pound first with euros (or
selling euros for pounds), and then selling the pound for
dollars, and finally selling that number of dollars for euros
would make a profit because we would be buying the pound
at a low euro price and selling the pound at a high euro price.
✓To check this logic, let’s go through the steps in a triangular

arbitrage.
✓Suppose the figures below at the foreign exchange trading
desk of Goldman Sachs in London of the exchange rates of
the euro relative to the pound and the dollar, and the dollar
relative to the pound:
€1.4381/£ or £0.6954/€
€0.8408/$ or $1.1893/€
$1.7395/£ or £0.5749/$
✓Determine the arbitrage profits when the trader starts with
€10,000,000 and buys GBP (£).
TRIANGULAR ARBITRAGE DIAGRAM
EUR
USD GBP
USD 1.7395/GBP
GBP 0.5749/USD
Note: The exchange rate beneath the arrows indicate the revenue to the seller from selling the currency at one node to purchase
the currency at another node. For example, at the EUR node, selling the euro yields 0.6954 GBP going in the clockwise
direction, and it yields 1.1893 USD going in the counterclockwise direction.
✓Step 1. The revenue in pounds of selling €10,000,000 at the
direct cross-rate = €10,000,000 X (£0.6954/ €) = £6,954,000
✓Step 2. Because the exchange rate of dollars per pound is

($1.7395/£), we would be able to sell £6, 954,000 for dollars
to get £6,954,000 X ($1.7395/£) = $12,096,483
✓Step 3. Because the exchange rate of euros per dollar is

€0.8408/$, we would sell the $12,096,483 for euros to get
$12,096,483 X (€0.8408/$) = €10,170,722
✓If we had truly been able to make these transactions
simultaneously, we would have made:
€10, 170,722 – €10,000,000 = €170,722
✓for an instantaneous rate of return of 1.71%

(€170,722/ €10,000,000) X 100%
Good and Bad Triangular Arbitrage
✓A profitable triangular arbitrage will depend on the
direction taken.
✓In this example we made money by selling euros for

pounds rather than by going in the counterclockwise
direction
✓It also shows how we would have lost money if we

had chosen to go in the wrong direction.
A good
arbitrage….. FINISH: START:
EUR 10,170,722 EUR 10,000,000
EUR
USD GBP
USD 12,096,483 USD 1.7395/GBP GBP 6,954,000

Note : The arrows indicate selling of the currency at the starting node for the currency at
the ending node. The exchange rates express the amount of ending node currency obtained
from selling one starting node currency.
A bad
arbitrage…..
START: FINISH:
EUR 10,000,000 EUR 9,832,701
EUR
USD GBP
USD 11,893,000 GBP 0.5749/USD GBP 6,837,286
Note : The arrows indicate selling of the currency at the starting node for the currency at
the ending node. The exchange rates express the amount of ending node currency obtained
from selling one starting node currency.
✓Three (3) important things to note about triangular arbitrage:
✓First, to be an effective arbitrage, the transactions must all
be conducted simultaneously.
✓Because it is not physically possible to do all three

transactions simultaneously, there is some risk involved in
any attempted triangular arbitrage
✓Why? Because prices might change between transactions.

✓Second, as traders place orders to conduct the arbitrage,
market forces are created that bring the quoted cross-rate
back into alignment with the indirect cross-rate.
✓In our example we have £0.6954/€ > £0.5749/$ * $1.1893/€

✓ Third, the arbitrage need not start by using the euro to
purchase pounds.
✓The triangular arbitrage would be profitable starting from

any of the currencies
✓As long as we trade in the same direction and go completely

around the triangle.
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 with a forward contract.
✓Covered interest arbitrage tends to force a relationship
between forward rate premiums and interest rate
differentials.
✓Has two components:
▪ Interest arbitrage: the process of capitalizing on the difference
between interest rates between two countries.
▪ Covered: hedging the position against interest rate risk.
Example
You desire to capitalize on relatively high rates of interest in
the United Kingdom and have funds available for 90 days.
The interest rate is certain; only the future exchange rate at
which you will exchange pounds back to U.S. dollars is
uncertain.
You can use a forward sale of pounds to guarantee the rate at

which you can exchange pounds for dollars at some future
time.
✓Assume the following information:
▪You have $800,000 to invest.
▪The current spot rate of the pound is $1.60.
▪The 90-day forward rate of the pound is $1.60.
▪The 90-day interest rate in the United States is 2 percent.
▪The 90-day interest rate in the United Kingdom is 4
percent.
✓Based on this information, you should proceed as follows:
▪On day 1, convert the $800,000 to £500,000 and deposit
the £500,000 in a British bank.
▪On day 1, sell £520,000 90 days forward. By the time the
deposit matures, you will have £520,000 (including
interest).
▪In 90 days when the deposit matures, you can fulfill your
forward contract obligation by converting your £520,000
into $832,000 (based on the forward contract rate of $1.60
per pound
✓Suppose you are given the following exchange rates and
one-year interest rates.
BID QUOTE ASK QUOTE
Euro spot rate $1.12 $1.13
Euro 1 – year forward rate $1.12 $1.13
DEPOSIT RATE LOAN RATE
Interest Rate on Dollars 6.0% 9.0%
Interest Rate on Euros 6.5% 9.5%
✓You have $100,000 to invest for one year. Would you
benefit from engaging in covered interest arbitrage? How?
✓Convert $100,000 to euros (ask quote):
$100,000/$1.13 = €88,496
✓Calculate accumulated euros over one year at 6.5 percent:
€88,496 (1.065) = €94,248
✓Sell euros for dollars at the forward rate (bid quote):
€94,248 * $1:12 = $105,558
✓Determine the yield earned from covered interest arbitrage:
($105,558 - $100,000)/$100,000 = 0.05558, or 5.558%
✓The yield is less than if you had invested the funds in the
United States. Thus, covered interest arbitrage is not feasible.
Comparison of Arbitrage Effects
✓Locational arbitrage ensures that quoted exchange rates are
similar across banks in different locations.
✓Triangular arbitrage ensures that cross exchange rates are set

properly.
✓Covered interest arbitrage ensures that forward exchange

rates are set properly.
✓Any discrepancy will trigger arbitrage, which will then

eliminate the discrepancy. Arbitrage thus makes the foreign
exchange market more orderly.
Interest Rate Parity (IRP)
✓Market forces cause the forward rate to differ from
the spot rate by an amount that is sufficient to offset
the interest rate differential between the two
currencies.
✓Then, covered interest arbitrage is no longer feasible,

and the equilibrium state achieved is referred to as
interest rate parity (IRP).
✓Money Market Information:
Switzerland UK
30 – Day interest rate 2.594% p.a. 6% p.a.
✓Foreign Exchange Market Information

Spot Swf 2.6556/pound
1 month forward Swf 2.6481/pound
✓Assume we have Swf 100,000 to invest in the UK where

money market rates are higher or invest in Switzerland
✓The concept here is called interest rate parity (IRP).
✓If interest rate parity exits, investors cannot get more
than what the home money market offers.
✓That is, the two investments in Switzerland and UK
yield the same.
✓If IRP is violated, there will be covered interest
arbitrage by arbitrageurs. This will go on until IRP is
re-established.
✓Derivation of Interest Rate Parity
1 + 𝑖ℎ
𝜌= −1
1 + 𝑖𝑓
Where:
𝜌 = forward premium or discount
𝑖ℎ = home interest rate
𝑖𝑓 = foreign interest rate
✓Determining the forward premium
𝐹−𝑆
𝜌= ≅ 𝑖ℎ − 𝑖𝑓 Implications: If the
𝑆 forward premium is
Where: equal to the interest
𝜌 = forward premium or discount rate differential as
𝑖ℎ = home interest rate just described, then
covered interest
𝑖𝑓 = foreign interest rate arbitrage will not be
F = forward rate in home currency feasible.
S = spot rate in home currency
✓Considerations When Assessing Interest Rate Parity:
▪Transaction costs
▪Political Risk
▪Differential Tax Laws
(BBAF 402)
ABUBAKAR MUSAH
Relationships among Inflation, Interest Rates and
Exchange Rates
Outline:
✓Purchasing Power Parity (PPP) theory
✓Implications of PPP for exchange rate changes.
✓International Fisher effect (IFE) theory
✓Implications of IFE for exchange rate changes.

Purchasing Power Parity (PPP)
✓Recall: When one country’s inflation rate rises
relative to that of another country, decreased
exports and increased imports depress the
country’s currency.
✓The theory of purchasing power parity (PPP)

attempts to quantify this inflation - exchange rate
relationship.
Interpretation of PPP
✓Absolute Form of PPP (“law of one price”)
▪Without international barriers, consumers shift their
demand to wherever prices are lower.
▪Prices of the same basket of products in two

different countries should be equal when measured
in common currency.
Interpretation of PPP
[
✓Relative Form of PPP

▪Due to market imperfections, prices of the same
basket of products in different countries will not
necessarily be the same, but the rate of change in
prices should be similar when measured in common
currency.
Rational Behind PPP Theory
[
✓Exchange rate adjustment is necessary for the

relative purchasing power to be the same whether
buying products locally or from another country.
✓If the purchasing power is not equal, consumers

will shift purchases to wherever products are
cheaper until the purchasing power is equal.
Rationale Behind PPP Theory
✓Suppose U.S. inflation > U.K. inflation.
 U.S. imports from U.K. and  U.S.
exports to U.K., so £ appreciates.
✓This shift in consumption and the appreciation of the
£ will continue until
 in the U.S., priceU.K. goods  priceU.S. goods, &
 in the U.K., priceU.S. goods  priceU.K. goods.
Derivation of PPP
✓PPP shows the relationship between the exchange rate and
relatives inflation rate.
✓This is represented in equation form as
1 + 𝐼ℎ
𝑒𝑓 = −1
1 + 𝐼𝑓
If 𝐼ℎ > 𝐼𝑓 , then 𝑒𝑓 should be positive which implies that the
foreign currency will appreciate when the home country’s
inflation exceeds the foreign country’s inflation
Derivation of PPP
✓A simplified but less precise PPP expression is
presented below:
𝑒𝑓 ≃ 𝐼ℎ − 𝐼𝑓
✓The percentage change in the exchange rate should

be approximately equal to the difference in inflation
rates between the two countries.
✓PPP assumes the validity of the law of one price.
✓The law of one price says that, the dollar (or the cedi)
price of any given commodity should be the same
everywhere in the world.
✓The law of one price would only hold if markets
were free and frictionless and also all goods were
traded internationally.
✓If these conditions do not exist, there would be
commodity arbitrage.
✓For example if the price of gold in USA were
$400/ounce and the exchange rate was US$1 = £.500,
then the price of gold in UK must be £200/ounce.
Should the price in UK be different from £200/ounce,
then arbitrage will take place.
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
4
PPP line
-3 -1 1 3 % D in the
foreign
currency’s
-2 spot rate
-4 12
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
4
PPP line
Increased
purchasing
power of
foreign 2
goods
-3 -1 1 3 % D in the
Decreased foreign
purchasing currency’s
-2 power of spot rate
foreign
goods
-4 13
Testing the PPP Theory
✓Conceptual Test
▪Plot the actual inflation differential and exchange rate %
change for two or more countries on a graph.
▪If the points deviate significantly from the PPP line over
time, then PPP does not hold.
Testing the PPP Theory
✓Statistical Test of PPP
▪Apply regression analysis to historical exchange rates and
inflation differentials.
▪Empirical studies indicate that the relationship between
inflation differentials and exchange rates is not perfect
even in the long run.
▪However, the use of inflation differentials to forecast
long-run movements in exchange rates is supported.
Why PPP Does Not Occur
PPP may not occur consistently due to:
confounding effects
▪Exchange rates are also affected by differentials in
interest rates, income levels, and risk, as well as
government controls.
lack of substitutes for traded goods.
▪ If substitute goods are not available domestically,
consumers may not stop buying imported goods.
International Fisher Effect (IFE)
✓According to the Fisher effect, nominal interest rates
contain
▪a real rate of return and
▪an anticipated inflation.
✓If the same real return is required, differentials in

interest rates may be due to differentials in expected
inflation.
✓According to PPP, exchange rate movements are
caused by inflation rate differentials.
✓The international Fisher effect (IFE) theory suggests
that
▪currencies with high interest rates will have high
expected inflation (due to the Fisher effect)
▪and the relatively high inflation will cause the
currencies to depreciate (due to the PPP effect).
✓Hence, investors hoping to capitalize on a higher

foreign interest rate should earn a return not better
than what they would have earned domestically.
Derivation of IFE
✓It shows the relationship between the interest rate (i)
differential between two countries and expected
exchange rate (e)
1 + 𝑖ℎ
𝑒𝑓 = −1
1 + 𝑖𝑓
The IFE theory contends that if 𝑖ℎ > 𝑖𝑓 , then 𝑒𝑓 will be
positive because the relatively low foreign interest rate
reflects relatively low inflationary expectations in the
foreign country
Numerical Example
Assume that the interest rate on a one-year insured home country
bank deposit is 11%, and the interest rate on a 1-year insured foreign
bank deposit is 12%:
1+𝑖ℎ
𝑒𝑓 = − 1,
1+𝑖𝑓
1+11%
𝑒𝑓 = − 1 = −0.89%
1+12%
For the actual returns of these two investments to be similar from the
perspective of investors in the home country, the foreign currency
would have to depreciate by 0.89%
Graphic Analysis of the International Fisher Effect
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Lower
returns from IFE line
investing in 2
foreign
deposits
-3 -1 1 3 % D in the
foreign
Higher currency’s
returns from spot rate
-2 investing in
foreign
deposits
-4 22
Tests of the IFE
✓A statistical test can be developed by applying
regression analysis to the historical exchange rates
and nominal interest rate differentials:
ef = a0 + a1 { (1+ih)/(1+if) – 1 } + m
✓The appropriate t-tests are then applied to a0 and a1,

whose hypothesized values are 0 and 1 respectively.
23
Why the IFE Does Not Occur
✓Since the IFE is based on PPP, it will not hold when
PPP does not hold.
✓For example, if there are factors other than inflation

that affect exchange rates, the rates will not adjust in
accordance with the inflation differential.
24
Comparison of the IRP, PPP, and IFE
✓Although all three theories relate to the determination of exchange
rates, they have different implications.
▪ IRP focuses on why the forward rate differs from the spot rate and
on the degree of difference that should exist. It relates to a specific
point in time.
▪ PPP and IFE focus on how a currency’s spot rate will change over
time.
▪ Whereas PPP suggests that the spot rate will change in accordance
with inflation differentials, IFE suggests that it will change in
accordance with interest rate differentials.
▪ PPP is related to IFE because expected inflation differentials
influence the nominal interest rate differentials between two
countries.
Comparison of IRP, PPP, and IFE Theories
Interest Rate Parity Forward Rate

(IRP) Discount or Premium
Interest Rate Fisher Inflation Rate

Differential Effect Differential
Purchasing
Power Parity (PPP)
International Exchange Rate
Fisher Effect (IFE) Expectations
26
(BBAF 402)
ABUBAKAR MUSAH
Forecasting Exchange Rates
✓Explain why firms forecast exchange rates.
✓Describe the common techniques used for forecasting.
✓Explain how forecasting performance can be evaluated.
Why Firms Forecast Exchange Rates
✓Hedging decisions
▪ Whether a firm hedges may be determined by its forecasts of
foreign currency values.
✓Short-term investment decisions
▪ Corporations sometimes have a substantial amount of excess
cash available for a short time period. Large deposits can be
established in several currencies.
✓Capital budgeting decisions
▪ When an MNC’s parent assesses whether to invest funds in a
foreign project, the firm takes into account that the project may
periodically require the exchange of currencies.
Why Firms Forecast Exchange Rates
✓Earnings assessment
▪The parent’s decision about whether a foreign
subsidiary should reinvest earnings in a foreign
country or remit earnings back to the parent may
be influenced by exchange rate forecasts.
✓Long-term financing decisions

▪MNCs that issue bonds to secure long-term funds may
consider denominating the bonds in foreign currencies.
Forecasting Techniques
1) Technical Forecasting
2) Fundamental Forecasting
3) Market-Based Forecasting
✓Technical Forecasting
▪Involves the use of historical exchange rate data to predict
future values.
✓Limitations of technical forecasting:
▪Focuses on the near future.
▪Rarely provides point estimates or range of possible future
values.
▪Technical forecasting model that worked well in one
period may not work well in another.
Fundamental Forecasting
✓Based on fundamental relationships between economic variables and
exchange rates
✓Use of sensitivity analysis for fundamental forecasting
▪ Considers more than one possible outcome for the factors exhibiting
uncertainty.
✓Use of PPP for fundamental forecasting
▪ While the inflation differential by itself is not sufficient to accurately
forecast exchange rate movements, it should be included in any
fundamental forecasting model.
✓Limitations of fundamental forecasting include:
▪ Unknown timing of the impact of some factors.
▪ Forecasts of some factors may be difficult to obtain.
▪ Some factors are not easily quantified.
Market-Based Forecasting
✓Using the spot rate: Today’s spot rate may be used as a forecast of
the spot rate that will exist on a future date.
✓Using the forward rate to forecast the future spot rate:
E ( e) = p
( S )− 1
E ( e) = F
where
E(e) = expected percentage change in the exchange rate
p = percentage by which the forward rate (F)
exceeds the spot rate (S)
▪ FR should serve as a reasonable forecast for the future spot rate

because otherwise speculators would trade forward contracts (or
futures contracts) to capitalize on the difference between the
forward rate and the expected future spot rate.
✓Long-Term Forecasting with Forward Rates
▪ Long-term exchange rate forecasts can be derived from long-term
forward rates.
▪ The forward rate is typically more accurate when forecasting
exchange rates for short-term horizons than for long-term
horizons.
✓Implications of the IFE for Forecasts

▪ Since the forward rate captures the interest rate differential (and
therefore the expected inflation rate differential) between two
countries, it should provide more accurate forecasts for currencies
in high-inflation countries than the spot rate
Mixed Forecasting
✓Use a combination of forecasting techniques
✓Mixed forecast is then a weighted average of the various
forecasts developed.
Guidelines for Implementing a Forecast

✓Apply forecasts consistently within the MNC
✓Measure impact of alternative forecasts
✓Consider other sources of forecasts
Forecast Error
READ ON FORECAST ERROR

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INTERNATIONAL TRADE FINANCE

Over time as they recognize additional foreign

MNCs such as Colgate-Palmolive, Coca-Cola, ExxonMobil

It is equally important to companies with no international

Such economic characteristics can affect the foreign

Domestic competitors may reduce their costs by

Firm that engage in some form of international business.

Their managers conduct international financial

Examples include: Smoothie Factory, Eazi-Sites,

Acquisitions of existing operations in foreign countries

In general, any method of conducting business that requires

The optimal international business method may depend on

foreign economic conditions

When managers make multinational finance decisions that

E (CF¢, t ) = expected cash flows to be received at

Its financial decisions determine its exposure to the

❖Explain the key components of the balance of payments.

It accounts for transactions by businesses,

❖ Capital Account: summary of flow of funds resulting from

❖ Financial Account: refers to special types of investment,

❖Includes the value of financial assets transferred

❖Includes patents and trademarks.

❖Relatively minor to financial account.

Inflation: Current account decreases if inflation increases relative to

National Income: Current account decreases if national income

Credit Conditions: Tend to tighten when economic conditions weaken,

❖ Business Laws: Firms in countries with more restrictive bribery laws

❖ Tax Breaks: Though not necessarily a subsidy, still a form of

❖Country Trade Requirements: Requiring various forms or obtaining

❖Country Security Laws: Governments may impose certain

❖Policies to Punish Country Governments: Many expect countries to

❖How exchange rates may correct a balance of trade deficit:

❖Why exchange rates may not correct a balance of trade deficit:

o Prearranged international trade transactions: International transactions cannot

o Actions by one government to weaken its currency causes

o Government attempts to influence exchange rates can

❖Managers of privately owned businesses are motivated to ensure

❖The current account is a broad measure of the country’s

❖The capital account measures the value of financial and

❖The financial account consists mainly of payments for direct

❖In addition, MNCs have commonly used outsourcing in recent

❖Thus, outsourcing is another reason for the increase in

❖ High labor costs, high inflation, a high national income, low

❖ Although some countries attempt to correct current account

❖ Several agencies facilitate the international flow of funds by

2. Should Trade Restrictions be Used to Influence Human Rights

3. There has been considerable momentum to reduce or remove

▪ International money market

▪ International credit market

▪ International bond market

▪ International stock markets

✓ Large commercial banks serve this market by holding inventories of

✓ Individuals rely on the foreign exchange market when they travel to

✓ Exchange rate specifies the rate at which one currency can be

✓ It is the rate at which one currency can be converted to another. It is

✓Agreements on Fixed Exchange Rates

✓Floating Exchange Rate System (1973)

✓ Foreign exchange dealers serve as intermediaries in the foreign

✓ Spot Market: A foreign exchange transaction for immediate exchange

✓ Spot Market Structure: Trading between banks occurs in the interbank

✓ Spot market time zones: Foreign exchange trading is conducted

✓ Bid/Ask spread of banks: The bid/ask spread covers the bank’s

✓ Comparison of Bid/Ask spread among currencies