INTERNATIONAL FINANCIAL MANAGEMENT

The Foreign Exchange market, also reIerred to as the 'FOREX or 'Forex or 'Retail Iorex
or 'FX or 'Spot FX or just 'Spot is the largest Iinancial market in the world, with a volume oI
over $4 trillion a day. II you compare that to the $25 billion a day volume that the New York Stock
Exchange trades, you can easily see how enormous the Foreign Exchange really is. It actually equates
to more than three times the total amount oI the stocks and Iutures markets combined.
To put it in very simple terms, the Ioreign exchange market is a currency market, where
investment banks, institutions, commercial companies, and individual investors go to buy, sell, and
ultimately swap one currency Ior one another.
DiIIerent currencies are used in diIIerent places around the world. In the United States, we
use the US dollar, which is our currency. In Australia, the oIIicial currency is the Australian Dollar.
In Great Britain, they use the Pound. Europe uses the Euro.
All oI these currencies have a diIIerent value, which is dependent on other currencies.
FOREIGN EXCHANGE RISK MANAGEMENT TOOLS
Foreign exchange risks relate to adverse currency rate Iluctuations that result in lost
purchasing power and reduced proIits. Consumers lose purchasing power Ior imported goods as
domestic exchange rates decline. Conversely, multinational businesses suIIer when domestic
exchange rates advance. At that point Ioreign proIits lose value when converted back into domestic
currency. All participants within the global economy may use currency swaps, derivatives and
diversiIication strategies as tools to manage Ioreign exchange risks.
CURRENCY SWAPS
Currency swaps exchange payments in diIIerent currencies between two trading partners. For
eIIiciency, currency swaps Ieature netting, where the winning party receives one payment at the end
oI the swap term. Netting balances the diIIerences in currency valuations that occur during the swap
agreement. Currency swaps are oIten packaged with interest rate swaps, which manage competing
interest rate risks associated with diIIerent countries. Interest rate swaps exchange payments between
two parties at adjustable and Iixed interest rates. Lenders and borrowers that extend and receive
credit in Ioreign exchange denominations can use these swap agreements as Ioreign exchange risk
management tools.

EXAMPLE
A Canadian company enters into a currency swap with a US company Ior a period oI 4 years.
At the beginning they exchange 1M USD Ior 1.1M CAD. The Canadian company will pay Iixed rate
and US Company will pay the variable rate at the beginning oI each period. What will happen at the
end oI the 2nd year, given that,




The process oI a currency swap is the Iollowing:
1. At beginning, exchange principals
Canadian company gives 1.1M CAD and receives 1M USD and vice versa
2. At the end oI each period, exchange interest Ior the borrowed currency
Canadian company pays US company the interest Ior 1M USD and vice versa
3. At the end oI the swap, return principals
Canadian company gives US company back the 1M USD and vice versa
One must note that Ior the Iixed-rate payer, it will use the Iixed rate at the beginning oI the
swap to calculate the interest to pay at the end oI each period. ThereIore, Ior the Canadian company,
it will use 3 as the interest rate however it changes subsequently. So the Canadian company will
pay 0.03 * 1M USD 30k USD at the end oI the 2
nd
year.
For the variable rate payer, they will use the variable rate at the beginning oI each period. So,
they will use 4 to calculate the interest to pay at the end oI the 2
nd
year. So the US company has to
pay 0.04 * 1.1 CAD 44k CAD.
Initial Fixed Rate t0 3
Fixed Rate at the beginning
oI the 2nd year (t1) 4
Variable Rate at t0 2
Variable Rate at t1 4
Variable Rate at t2 3
CURRENCY DERIVATIVES
Currency derivatives Iunction as Ioreign exchange risk management tools because they allow
investors to lock in predetermined exchange rates Ior set periods oI time. Currency derivatives
include Iorwards, options and Iutures contracts. Forwards are customized agreements between two
parties to negotiate Ioreign exchange rates at later points in time. Because oI their high levels oI
customization, Iorwards are illiquid agreements. Liquidity describes your ability to exit out oI a
Iinancial agreement or sell any asset Ior cash.
For liquidity purposes, currency options and Iutures trade on organized Iinancial exchanges,
such as the Chicago Mercantile Exchange. In exchange Ior premium costs, investors buy options that
carry rights to accept or reject Ioreign exchange transactions at predetermined exchange rates.
Futures, however, enIorce currency delivery and acceptance at their Iormerly agreed upon exchange
rates. Multinational businesses use currency derivatives to preserve proIits and counter exchange-rate
volatility.
EXAMPLE
A jeweller who is exporting gold jewellery worth USD 50,000, wants protection against
possible Indian Rupee appreciation in Dec `09, i.e. when he receives his payment. He wants to lock-
in the exchange rate Ior the above transaction. His strategy would be:
One USD - INR contract size USD 1,000
Sell 50 USD - INR Dec '09 Contracts
(on 15th Jul '09)
44.6500
Buy 50 USD - INR Dec '09 Contracts in Dec '09 44.3500
Sell USD 50,000 in spot market 44.35 in Dec '09 (Assume that initially Indian rupee depreciated ,
but later appreciated to 44.35 per USD as Ioreseen by the exporter by end oI Dec '08)
ProIit/Loss Irom Iutures (Dec '09 contract) 50 * 1000 *(44.65 44.35)
0.30 *50 * 1000
Rs 15,000
The net receipt in INR Ior the hedged transaction would be: 50,000 *44.35 15,000
2,217,500 15,000 Rs 2,232,500. Had he not participated in Iutures market, he would have got
only Rs 2,217,500. Thus, he kept his sales unexposed to Ioreign exchange rate risk.
DIVERSIFICATION
DiversiIication works best when investors purchase uncorrelated assets. Correlation describes
the tendency Ior assets and prices to shiIt together in unison. In terms oI managing currency risks,
investors can diversiIy both their Ioreign exchange reserves and business portIolios. For example,
private individuals can establish Ioreign exchange reserves that hold U.S. dollars and Brazilian real to
manage risks while allowing Ior long-term growth in purchasing power. Relative to Brazil, the
United States is a mature economy that is associated with stability. In global Iinancial crisis, the
dollar strengthens as Ioreign investors covet risk-Iree U.S. Treasuries. Meanwhile, the Brazilian real
is associated with an emerging market that oIIers increased growth potential alongside heightened
risks.
Beyond assembling Ioreign exchange reserves, business entities expand internationally to
diversiIy markets Ior their products. Smaller investors that lack the capital to establish overseas
businesses can purchase shares oI stock within multinational corporations or explore global mutual
Iund investments.
EXAMPLE
An investor who wants a more aggressive, high risk proIile, has a mix oI stocks oI large cap
and small cap companies as a major part oI the portIolio, maybe even as much as 90, with the
remaining mix being 10 in bonds and cash. The more conservative the investor desired his
portIolio, having a low risk proIile, the more bonds and cash the portIolio would contain, with only
maybe 20 oI stocks in the portIolio.