MIB 2022 - Grenoble

Assessment

International Financial Individual assessment 50%

Assign. 1- Due date OCT 8th (15%)
Risk Management Assign. 2 on Part 1 only: Due date OCT 12th(15%)
Assign. 3 on all material: Due date OCT 27th
(15%)
Mohamad Hassan Abou Daya
Email: Mohamad-hassan.abou-daya@grenoble-em.com A grade for in-class quizzes out of 20 (based on
the 5 sessions we have together)

1.5 hour exam OCT 13th(Last

1 4 session) 40%

Aims of the module Reading list

To describe the multinational environment Textbook: Shapiro, A. Multinational financial

To focus on the financial risks inherent in management, John Wiley.
international business and the available
Additional reading material:
opportunities
To understand key issues and concepts of foreign Eiteman, D., Stonehill, A. and Moffett, M.
exchange and derivatives markets Multinational Business Finance.
To familiarize with the hedging and financing using
derivatives in the multinational environment context
Slides follow the textbook and are developed
To give tools to deal with the foreign exchange and
from slides of J.F. Greco, California State
to manage the currency exchange risk
2 5 University provided by J. Wiley & Sons.

Outline CHAPTER 1
Part 1 (6h) chapters 1-2-4 (Shapiro, 9th or 10th ed)
Multinational corporation (MNC), arbitrage relationships
Introduction: Multinational
Part 2 (6h) chapters 7-8-9 (Shapiro, 9th or 10th ed)
Risks can be covered by derivatives. Foreign exchange
Enterprise and Multinational
markets, foreign currency derivatives Financial Management
(Session 3 on forward contracts; Session 4 on options)

Part 3 (3h) chapter 10 (Shapiro, 9th or 10th ed)

Foreign exchange risks fluctuations
3 Example, Wrap-up, Q&A, sample final exam. 6
 THE RISE OF THE MULTINATIONAL THE PROCESS OF OVERSEAS
CORPORATION EXPANSION

The MNC: A Definition OVERVIEW:

a company with production and distribution facilities in more than
one country. A. Informal Exporting
with a parent company located in the home country and at least five
or six foreign subsidiaries
B. Sales Subsidiary Creation of Distribution
high degree of strategic interaction. System
C. Overseas Production
- Reasons to Go Global:
1. More raw materials D. Licensing
2. New markets
3. Minimize costs of production
4. Share risks and profit
7 10

THE RISE OF THE THE PROCESS OF OVERSEAS

MULTINATIONAL CORPORATION EXPANSION

A. Exporting
1- RAW MATERIAL SEEKERS
1. Minimal cost and risks
exploit markets in other countries
historically first to appear 2. Low profits
British Petroleum 3. Get to know the market
Exxon (previously known as Standard Oil) B. Sales Subsidiary / Creation of a Distribution System
1. Local office, warehouse system
2- MARKET SEEKERS
2. Greater customer service, new service facilities
Produce and sell in foreign markets
set up
Have heavy foreign direct investors
Represented today by firms such as: 3. Increased communication, marketing activities
8 11

THE RISE OF THE THE PROCESS OF OVERSEAS

MULTINATIONAL CORPORATION EXPANSION

C. Overseas Production
3- COST MINIMIZERS - PRODUCTION 1. Realize full sales potential
EFFICIENCY SEEKERS 2. Keep abreast of market developments
seek lower-cost production abroad
3. Fill orders faster
Their motive: to remain cost competitive
4. Greatest risk with greatest potential for profit
Represented today by firms such as:
D. Licensing
Texas Instruments 1. Alternative to setting up local production (less risk)
Intel 2. Relatively lower cash flow
Seagate Technology 3. Faster market entry time
9 12 4. Maintaining quality standards may be a problem
 What is different about
International Financial Management? Travelex at Lyon Saint Exupery

MNC National Corporation

Culture Known culture
may be hard to understand
Corporate All regulations and institutional practices are Regulations are well-
Governance uniquely different known
Foreign High exposure to foreign exchange risk: Only through
Exchange Risk import/export/subsidiaries import/export
Political Risk High exposure Negligible
What is different about International
Complexity Modified finance theories like cost of capital Standard theories
Financial Risk Management?
computations to account for foreign apply. No need for
complexities, use of derivatives, options, complex derivatives

13 16

Equilibrium Exchange Rates

CHAPTER 2

Foreign Currency Demand: derived from the demand

The Determination of assets.
Exchange Rates e.g., Americans demand German goods such as Mercedes autos
Foreign Currency Supply for euros:
- interpreted also as the demand for U.S.$
- derived from the demand of the Eurozone for
U.S. goods.
e.g. German demand for US goods such as Dell computers means
17 Germans must convert euros to US $ in order to buy.

Equilibrium Exchange Rates Equilibrium Exchange Rates

The exchange rate How Exchange Rates Change

is the price of one unit of foreign currency 1. Increased demand as more foreign goods are
expressed as a certain price in local currency demanded, more of the foreign currency is demanded
For example, $.99/ 2. The price of the foreign currency in local currency
increases.
Transactions Costs: Bid-Ask Spread used to
calculate the fee charged by the bank 3. Home Currency Depreciation
a. Foreign currency more valuable than the home currency.
Spot rate: price of the currency for immediate
delivery against the home currency.
Forward rate: price at which foreign exchange is Factors: Inflation rates, Interest rates, GNP growth rates
15 quoted for delivery at a specified future date 18
 Equilibrium Exchange Rates
CHAPTER 4
Example: Computing a Currency Appreciation or
depreciation of Euro against $
= (e1 - e0)/ e0
Parity Conditions in International
where e0 = value at 0 of 1 euro in dollars
e1 = value at 1 of 1 euro in dollars
Finance and Currency
If it is positive: appreciation Forecasting
If it is negative: depreciation

19

ARBITRAGE
Sample Problem AND THE LAW OF ONE PRICE

LAW OF ONE PRICE

Identical goods sell for the same price worldwide.

Theoretical basis: If the prices after exchange-rate

adjustment were not equal, arbitrage for the goods
worldwide ensures that eventually they will.
20 23

ARBITRAGE
Sample Problem AND THE LAW OF ONE PRICE

If a currency falls by 20%, by how Parity Conditions

much should it increase to get back 1. Purchasing Power Parity (PPP)
to the same level? 2. Fisher Effect (FE)
3. International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)

21 24
 PURCHASING POWER PARITY EXAMPLE: Approximated PPP

It states that spot exchange rates between currencies will Assume that US and Switzerland are running
change to the differential in inflation rates between countries.
(relative version of PPP, most commonly used) inflation rates of 5% and 3% respectively, and
In other words, the exchange rate of one currency against the spot rate is SFr1=$0.75
another will adjust to reflect changes in the price levels of the
two countries
In mathematical terms: Then, compute the best prediction for the
value in dollars of 1 SFr in 1 year using the
PPP relationship and its approximation.
where et = future spot rate, e0 = spot rate,
ih = home inflation (price level increase in home country),
25 if = foreign inflation, t = the time period. 28

EXAMPLE: Application of PPP PURCHASING POWER PARITY

Assume that US and Switzerland are running Implications of PPP:

inflation rates of 5% and 3% respectively, and
the currency with the higher inflation
the spot rate is SFr1=$0.75
rate is expected to depreciate relative to
Then, compute the best prediction for the the currency with the lower rate of inflation
value in dollars of 1 SFr in 3 years using the
PPP relationship.

26 29

PURCHASING POWER PARITY THE FISHER EFFECT (FE)

If purchasing power parity is expected to hold, then the

best prediction for the one-period spot rate should be THE FISHER EFFECT (FE)
Definition:
states that nominal interest rates (r) are a
A more simplified but less precise relationship for 1 year
function of the real interest rate (a) and a premium (i)
period is
for inflation expectations.

that is, Exact (1+r)=(1+a)(1+i)

the percentage change should be approximately Approximate: r = a + i

27 equal to the inflation rate differential. 30

 THE FISHER EFFECT (FE)

SAMPLE QUESTION

Using IFE to forecast US$ and SFr rates

1 year interest rate is 2% on Swiss francs
and 7% on U.S. dollars.
1) If the current exchange rate is Sfr 1 =$0.91,
what is the expected future exchange rate in
one year?
2) If a change in expectations regarding future
U.S. inflation causes the expected future spot
rate to rise to Sfr 1 =$ 1.00, what should happen
31 34 to the U.S. interest rate (assuming swiss interest
does not change)?

THE FISHER EFFECT THE INTERNATIONAL FISHER EFFECT

Real Rates of Interest: Implications of IFE

1. Should tend toward equality everywhere through arbitrage.
2. With no government interference nominal rates vary by 1. Currency with the lower interest
inflation differential or rate is expected to appreciate relative to
rh - rf = ih - if the one with a higher rate
According to the Fisher Effect: countries with higher inflation 2. Financial market arbitrage:
rates have higher interest rates. insures interest rate differential is an
(The nominal interest rate differential should reflect the inflation unbiased predictor of change in future
rate differential and expected rates of return are equal in the
absence of government intervention)
spot rate.
32 35

THE INTERNATIONAL FISHER EFFECT INTEREST RATE PARITY THEORY

IFE STATES: Forward rate F and spot rate S :

the spot rate adjusts to the interest rate differential where rh = the home rate
between two countries
rf = the foreign rate
IFE = PPP + FE
et (1 rh ) t This formula can be easily interpreted / proved.
e0 (1 rf )t How?
Simplified IFE equation (approximation) if rf is relatively small The Theory states that approximately:
The forward premium or discount equals the
interest rate differential.
33 36 (F - S)/S = rh - rf
 SAMPLE QUESTION
CHAPTER 7
Interest rates in the U.S. is 10% per annum
Interest rates in Japan is 7% per annum
Spot rate for Yen is 0.003800 $ per Yen The Foreign Exchange Market
What is the 90-day forward rate of Yen?

37 40

INTEREST RATE PARITY THEORY INTRODUCTION

Covered Interest Arbitrage

1. Conditions required: interest rate differential does not
equal the forward premium or discount
2. Funds will move to a country with a more attractive
rate.
Market pressures develop:
a. As one currency is more demanded spot and sold
forward
b. Inflow of fund depresses interest rates
38 c. Parity eventually reached
The Currency Market
Definition: a place where money denominated
in one currency is bought and sold with money
denominated in another currency
Participants in Spot and Forward Markets
commercial banks, brokers, customers of
commercial and central banks, arbitrageurs,
traders, hedgers, speculators
Most transactions come from electronic trading
41

ORGANIZATION OF THE FOREIGN

COVERED INTEREST ARBITRAGE EXCHANGE MARKET

Example of covered arbitrage

SIZE OF THE MARKET
- Interest on British pounds is 12% in London
A. Largest financial market in the world
- Interest on U.S. $ is 7% in New York
- British pound spot rate is $1.95 2007: US$3.2 trillion/day, US$800 trillion/year
- 1-year forward is $1.87
B. Market Centers by Size (2007), daily turnover:
Assuming borrowing rate=lending rate, no bid-ask #1: London = $1.359 trillion
spread on the spot and forward, explain how an
arbitrager can take to profit the discrepancy in rates #2: New York= $664 billion
based on $1,000,000 or a 1,000,000 pounds #3: Zurich= $242 billion
transaction and a one year horizon. #4: Tokyo = $238 billion
39 42
 THE MARKET

QUOTATIONS
1. Quotes can be found in all major newspapers,
and on data providers (bloomberg)
2. Major currencies have 4 different quotes:
a. spot price
b. 30-day forward
c. 90-day forward
d. 180-day forward
3. Direct/indirect quotes: Direct quote gives the
home currency price (always in the numerator)
of one unit of foreign currency. Example:
$1.81/£ (direct quote in the U.S. for the pound)
43 46

THE SPOT MARKET THE FORWARD MARKET

Definition of a Forward Contract: an agreement

Calculating Cross Rates (example)
between a bank and a customer to deliver
Suppose you want to calculate the £/
- a specified amount of currency against another
You know £.5556
currency
then £
- at a specified future date and
Currency Arbitrage (SPOT transactions) - at a fixed exchange rate
1. If cross rates differ from one financial center to
Covered Interest arbitrage (Forward market arbitrage
another, and profit opportunities exist.
strategy)
2. Main purpose of a Forward: Hedging
price in another
44 47 the act of reducing risk exposure

Example:
TRIANGULAR Currency Arbitrage Hedging with a Forward Contract

Example: U.S company buys textile from England

Pound sterling is at $1.9422 in New York
Euro is offered at $1.4925 in Frankfurt
At the same time, London offers pounds at
1.2998Euros
Find an arbitrage strategy for a trader starting with
1,000,000 U.S. dollars.
45
with 1,000,000 pounds due in 90 days.
Spot price for pounds is $1.97
Exposure to risk of a raise of the pound
against the dollar.
Importer can hedge by immediately
negociating a 90 day forward at say $1.98
Then, importer has to pay $1.98 million in
90 days.
48
 FUTURES CONTRACTS

Forward vs. Futures Contracts

Basic Differences:
1. Trading Locations 5. Quotes
2. Regulation 6. Margins
3. Delivery 7. Credit risk
4. Size of contract 8. Transaction Costs
Advantages of Futures: Disadvantages of Futures:
1.) Easy liquidation 1.) Limited to major currencies
2.) Well-organized market 2.) Limited dates of delivery
49 52 3.) Low credit risk 3.) Rigid contract sizes

FUTURES CONTRACTS Additional Example

A Chinese company sells goods in the US
International Monetary Market (IMM) 1972: opened by
the Chicago Mercantile Exchange provides an outlet for and will receive 100,000USD upon delivery
hedging currency risk with futures contracts. in 6 months.
Definition of a Futures Contract: contracts written Futures quotes: 180d Chinese
requiring a standard quantity of an available currency Renminbi/USD Futures 0.1566 USD/RMB
at a fixed exchange rate at a set delivery date. ($1,000/contract)
Available Futures: up to 20 different currencies
Transaction costs: commission
Spot price of 6.44 RMB/$
Maintenance Margins: When the account balance What is the risk exposure of the Chinese
falls below the maintenance margin, a margin call may company?
50 be necessary to maintain the minimum balance 53 How to hedge using futures?

FUTURES CONTRACTS
CHAPTER 8
Global futures exchanges:
1. Chicago Mercantile Exchange (CME)
2. London International Financial Futures Exchange Options Markets
(L.I.F.F.E.)
3. Chicago Board of Trade (C.B.O.T.)
4. Singapore International Monetary Exchange
(S.I.M.E.X.)
5. Deutsche Termin Bourse (D.T.B.)
6. Hong Kong Futures Exchange (H.K.F.E.)
51 7. New York Mercantile Exchange (NYMEX)
 CURRENCY OPTIONS

Expiration Dates of Currency Options (can be ignored

for the exam. All options in the class are European)
Example of call option a. American: exercise date may occur any time up to the expiration
date.
b. European: exercise date occurs only at the expiration date and not
before.

Why Use Currency Options?

a. For the firm hedging foreign exchange risk when a future event is
very uncertain.
b. For speculators who profit from favorable exchange rate changes.
55 58

CURRENCY OPTIONS From a final exam (1/2)

OPTIONS Carrefour will receive ¥125 million (Japanese yen) in

Currency options offer another method to hedge
exchange rate risk
Definition: a contract from a writer (seller) that gives the
right not the obligation to the holder (buyer) to buy or sell
a standard amount of an available currency at a fixed
exchange rate for a fixed time period
Types:
- Calls give the owner the right to buy the currency
56 - Puts give the owner the right to sell the currency
three months.
It is thinking of buying 1 yen put option (contract size is
¥125 million) at a strike price of 0.008/ ¥ and with
maturity 3 months in order to protect against the risk of
changes in the value of the yen. The premium is 0.0005
per yen.
Alternatively, Carrefour could take a short position in a
three-month yen futures (contract size is ¥125 million) at a
price of 0.0079 per yen.
59 The current spot rate is ¥1 = 0.0078.

CURRENCY OPTIONS From a final exam (2/2)

What is the premium? Suppose Carrefour 's treasurer believes that the most likely
the price of an option that the writer charges the buyer value for the yen in 90 days is 0.00795, but the yen could
Exercise Price
go as high as 0.009 or as low as 0.007.
a. Sometimes known as the strike price.
b. The exchange rate at which the option holder can buy or sell a. Diagram Carrefour 's revenue in Euros with the strategy
the contracted currency with the put option and with the strategy with futures
Status of an option
a. In-the-money within its range of expected prices ( 0.007/yen-
Call: Spot > strike 0.009/yen). Ignore transaction costs and margins.
Put: Spot < strike
b. Out-of-the-money
Call: Spot < strike b. Calculate what Carrefour would gain or lose on the option
Put: Spot > strike and futures positions if the yen settled at its most likely
c. At-the-money
57 Spot = the strike 60 value $0.00795/yen.
 Two Additional Questions How does transaction risk arises?

Redo the Example of the Chinese Company (Chapter 10 Shapiro)

at the end of previous chapter.
- Option to sell 100,000$ at 650,000RMB in 6
months is available for a premium of
13,000RMB
How can the US company importing textile
from the UK implement a hedge using
options?
61
1. Accounting or Translation Exposure:
arises when reporting and consolidating
financial statements require conversion
from subsidiary to parent currency.
2. Transaction risk Exposure:
arises because exchange rate
changes alter the value of
future revenues and costs.
64

How Translation Risk Arises

Wrap Up Session
Translation Risk

Japan United States

£ Headquarters' £ Subsidiary
Risk Management of Subsidiary
Financials Consolidated Financials
Currency Risk ¥
Financials
$
£

Subsidiary Financials Germany

65

Objectives of this last chapter DESIGNING A HEDGING STRATEGY

Transaction and translation exposure

DESIGNING A HEDGING STRATEGY
Identify basic hedging strategies to manage A. Hedging Strategy: a management objective
these risks. B. Hedging: basic objective: Example:
Forward market hedge reduce/eliminate volatility of earnings as a result of
Money market hedge exchange rate changes
Option market hedge C. Hedging exchange rate risk
Describe each strategy, its cost and future 1. Hedging is a cost, not a profit-center
cash flows, pros and cons 2. Hedging should be evaluated as a
purchase of insurance.
63 66
 MANAGING TRANSACTION
EXPOSURE

METHODS OF HEDGING:
A. RISK SHIFTING, RISK SHARING
1. home currency invoicing
2. common in global business
3. firm will invoice exports in strong
currency, import in weak currency
4. Drawback:
it is not possible with informed
67 customers or suppliers. 70

MANAGING TRANSACTION
EXPOSURE
B. EXPOSURE NETTING: Money Market
Hedge (trident example, Chinese company
example hereafter):
a. offsetting exposures in one currency with
exposures in the same currency: gains and
losses on the two currency positions will offset
each other.
b. One cash flow can be offset by the same cash
flow of the opposite sign: Money market hedge.
C. USE OF CURRENCY DERIVATIVES: Forward
market hedge, Foreign currency options: Example of
Trident and sample exam
68

69