Department of Banking and Insurance

International Financial Management

8th Semester Final Examination
Study Manual

Maker: The Notorious

 Makers: The Notorious
International Financial Management

Sudipta Barua (6th Batch) Nur Naher (6th Batch)

Jannatul Maowa Puspa (6th Batch) MD. Obaidul Hasan(6th Batch)
Ayesha Siddiquea (6th Batch)

Reference:
01. International Financial Management
----------------- Jeff Madhura
 1 Introduction

 Multinational Corporation
Multinational corporations (MNCs) are defined as firms 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. The goal of these managers is to maximize their firm's
value, which is the same goal pursued by managers employed by strictly domestic
companies.
A multinational corporation (MNC) or transnational corporation (TNC) is a company
engaged in producing and selling goods or services in more than one country. It
ordinarily consists of a parent company located in the home country and a number of
foreign subsidiaries, typically with a high degree of strategic interaction among the units.
A multinational corporation (MNC) is like a giant company with branches in many
countries. It's not just selling products abroad, it actually has offices, factories, and workers
all over the world. Imagine a big tree with roots in one country and branches reaching
out to other countries, that's kind of like an MNC!
The main goal of these companies is to grow bigger and make more money, just like any
other business. They do this by using their global reach to find cheaper ways to make
things, reach new customers, and take advantage of different laws and regulations in
different countries.

 How Business Disciplines Are Used to Manage the MNC

Various business disciplines are integrated to manage the MNC in a manner that
maximizes shareholder wealth. Management is used to develop strategies that will
motivate and guide employees who work in an MNC and to organize resources so that
they can efficiently produce products or services. Marketing is used to increase consumer
awareness about the products and to monitor changes in consumer preferences.
Accounting and information systems are used to record financial information about
revenue and expenses of the MNC, which can be used to report financial information to
investors and to evaluate the outcomes of various strategies implemented by the MNC.
Finance is used to make investment and financing decisions for the MNC. Common
finance decisions include:
 whether to discontinue operations in a particular country
 whether to pursue new business in a particular country,
 whether to expand business in a particular country, and
 how to finance expansion in a particular country.

These finance decisions for each MNC are partially influenced by the other business
discipline functions. The decision to pursue new business in a particular country is based
on comparing the costs and potential benefits of expansion. The potential benefits of such
new business depend on expected consumer interest in the products to be sold
(marketing function) and expected cost of the resources needed to pursue the new
business (management function). Financial managers rely on financial data provided by
the accounting and information systems functions.

 MNCs Pursue International Business :

Multinational business has generally increased over time. Three commonly held theories
to explain why MNCs are motivated to expand their business internationally are the: (1)
theory of comparative advantage, (2) imperfect markets theory, and (3) product cycle
theory.

Comparative Advantage Theory

According to this theory, which rests on the doctrine of comparative advantage, each
nation should specialize in the production and export of those goods that it can produce
with highest relative efficiently and import those goods that other nations can produce
relatively more efficiently.

Underlying this theory is the assumption that goods and services can move internationally
but factors of production, such as capital, labor, and land, are relatively immobile.
Furthermore, the theory deals only with trade in commodities-that is, undifferentiated
products; it ignores the roles of uncertainty, economies of scale, transportation costs, and
technology in international trade; and it is static rather than dynamic.

Imagine a world with two countries:

 Country A: Really good at making shoes, but not so great at farming.

 Country B: Great at growing wheat, but not so good at making shoes.
According to the theory:

 Both countries should focus on what they're best at:

o Country A makes shoes and exports them to Country B.
o Country B grows wheat and exports it to Country A.
 This way, both countries benefit:
o Country A gets cheaper wheat than they could grow themselves.
o Country B gets cheaper shoes than they could make themselves.
 It doesn't matter if Country A is better at everything:
o Even if Country A could also grow wheat better, it still makes more sense
for them to specialize in shoes and trade with Country B for wheat.

Key points:

 Focus on your strengths: Trade what you're good at, buy what you're not good at.
 Everyone wins: Trade benefits both countries involved.
 It's not about being the best: Even if you're not the absolute best at something, you
can still benefit from trade.

Limitations:

 Doesn't consider everything: The theory doesn't account for factors like
transportation costs or new technologies.
 Static: It assumes things stay the same, but the real world is constantly changing.

Despite these limitations, the Comparative Advantage Theory is a valuable tool for
understanding why free trade can be beneficial for everyone

Imperfect Markets Theory

If each country's markets were closed to all other countries, then there would be no
international business. At the other extreme, if markets were perfect and thus the factors
of production (such as labor) easily transferable, then labor and other resources would
flow wherever they were in demand. Such unrestricted mobility of factors would create
equality in both costs and returns and thus would remove the comparative cost
advantage, which is the rationale for international trade and investment.
However, the real world suffers from imperfect market conditions where factors of
production are somewhat immobile.

These imperfections can include things like:

 Trade barriers: These are things like tariffs, quotas, and embargoes that make it
more expensive or difficult to import or export goods and services.
 Government regulations: These are laws and rules that can make it difficult for
businesses to operate in certain countries.
 Lack of information: Sometimes businesses don't have enough information about
the opportunities available in other countries.
 Transportation costs: It can be expensive to move goods and services from one
country to another.

Because of these imperfections, multinational companies (MNCs) like Gap and Nike often
have an advantage over local businesses. MNCs have the resources and knowledge to
overcome the challenges of doing business in foreign countries. They can also take
advantage of comparative advantages that exist in different countries. For example, Gap
might be able to make clothes more cheaply in China than it can in the United States.

In short, imperfect markets provide an incentive for MNCs to invest and do business in
other countries. This can be a good thing for both the MNCs and the countries they invest
in. MNCs can create jobs and bring new technologies to host countries, while host
countries can benefit from the economic growth that comes from foreign investment.

Product Cycle Theory

One of the more popular explanations as to why firms evolve into MNCs is the product
cycle theory. According to this theory,
Companies become multinationals because:
Start at home: They first find success in their own country due to market needs or lack of
competition.
Go global: They export their product to other countries with high demand.
Move production abroad: To save on costs and stay ahead of competitors, they might
start producing directly in other countries.
Keep innovating: They face more competition overseas, so they constantly improve their
product to stay unique and attractive.
In short, companies go from local success to global reach, adapting and innovating as
they go.
  How Firms Engage In International Business :

Methods to Conduct International :Business Firms use several methods to conduct

international business. The most common methods are:
1. International trade
2. licensing,
3. Franchising,
4. Joint ventures
5. Acquisitions of existing operations, and
6. Establishment of new foreign subsidiaries.

International trade
International trade is like selling your products (exporting) or buying materials (importing)
from other countries. It's a safe way for businesses to enter new markets or get cheap
supplies because they don't have to invest heavily abroad. Big companies like Boeing and
IBM do billions of dollars of business this way.
This approach entails minimal risk because the firm does not place any of its capital at risk.
If the firm experiences a decline in its exporting or importing, it can normally reduce or
discontinue that part of its business at a low cost.

Licensing
Licensing is an arrangement whereby one firm provides its technology (copyrights,
patents, trademarks, or trade names) in exchange for fees or other considerations. Many
producers of software allow foreign companies to use their software for a fee. In this way,
they can generate revenue from foreign countries without establishing any production
plants in foreign countries, or transporting goods to foreign countries.
Licensing is like renting out your intellectual property (ideas, inventions, designs etc.) to
other companies. They pay you in exchange for the right to use it, allowing you to make
money off your creation without the hassle of producing or selling it yourself. It's a win-
win for both sides!

Franchising
Under a franchising arrangement, one firm provides a specialized sales or service strategy,
support assistance, and possibly an initial investment in the franchise in exchange for
periodic fees, allowing local residents to own and manage the units.
Big company (franchisor) shares its brand, operating system, and know-how with a local
owner (franchisee).

 Franchisee runs a business under the big company's name, using their brand and
following their rules.
 Big company earns money from fees paid by the franchisee and might provide
some financial help to start-up.
 This lets the big company expand quickly worldwide without directly managing
every location.

Examples: McDonald's, Pizza Hut, Subway. This type of expansion is called "direct foreign
investment" because the big company invests money in other countries

Joint Ventures
Joint ventures are partnerships: Two or more companies work together on a specific
project or business venture.

Sharing is caring: Companies pool their resources (money, technology, knowledge)

and share the profits, losses, and work involved.

Why do it?: Joint ventures help companies:

Enter new markets: Partnering with a local company makes it easier to navigate a
foreign market.

Combine strengths: Each company brings their unique skills and resources to the
table, making the venture stronger.

Share risks: The costs and potential failures are split between partners.
Examples:
Cereal giant General Mills used Nestlé's global network to sell its products overseas

Acquisitions for Entering Foreign Markets

Companies often buy existing businesses in foreign countries to enter those markets
quickly. This is called an acquisition, and it means they directly own and control
everything.
Benefits:
Fast market entry: Skip starting from scratch, gain existing customers and market share.
Full control: Make all the decisions without relying on partners.
Example: Google buying search engines and other online services in many countries.

Downsides:
Expensive: Acquisitions cost a lot of money.
Risky: The bought business might not do well, leading to losses.
Hard to sell: If things go wrong, selling the business might be difficult.
In short, acquisitions are a fast way to enter foreign markets, but they can be expensive
and risky

Establishment of New Foreign Subsidiaries

Starting new businesses abroad (subsidiaries) to sell products:
Firms can also penetrate foreign markets by establishing new operations in foreign
countries to produce and sell their products. Like a foreign acquisition, this method
requires a large direct foreign investment. Establishing new subsidiaries may be preferred
to foreign acquisitions because the operations can be tailored exactly to the firm's needed.
It involves :

Big investment: Similar to buying foreign companies.

Advantage: Custom-built operations for your needs, potentially lower cost.
Drawback: Takes time to build and find customers, no immediate profits.
Basically, it's like planting a seed: takes time to grow, but you get exactly what you want.

 Summary of Methods
There are different ways for companies to do business internationally, from simple things
like selling stuff abroad (international trade) to more complex things like buying foreign
companies or starting their own in other countries (direct foreign investment or DFI).
Easy: Trade, licensing are simple, no direct investment in foreign operations.
Medium: Franchising, joint ventures need some investment, but not much.
Hard: Buying companies or starting your own abroad takes a lot of investment.
Many companies use a mix of these methods, for example selling products abroad and
also licensing their technology to foreign companies.
So, the simpler the method, the less investment it needs, but the more complex, the more
control the company has over its foreign operations
 2 Balance of Payment & Exchange Rate
 Many MNCs are heavily engaged in international business such as exporting,
importing on direct foreign investment (DFI) in foreign countries
 The transaction arising from international business cause money flows from one
country to another. Basically, the balance of payment is a measure of international
money flows.

 Balance of Payment: The summary of transactions between domestic and

foreign residents for a specific country over a specific period of time. It
represents an accounting of a country's international transactions for a period,
usually a quarter on a year.A balance of payment is composed of 3 accounts:
(1) Current account
(2) Financial account
(3) Capital account.
1) Current account: The Current account measures the flow of funds between one
country and other countries due to purchase of goods and services on to income
generated by assets.
 Current account consists of 3 components:
1) Merchandise (goods) & services
2) Primary income payments
3) Secondary income

A) Payment of merchandise (goods) & services:

Merchandise exports and imports represent tangible products such as smartphones and
clothing that are transported between countries.
 Service exports & imports represent tourism & other services (legal insurance,
consulting services) provided for customers based in other countries.
 Service exports by united states result in an inflow of fund and vice versa
 Balance of trade: The difference between total exports and imports is referred to
as the balance of payment.
  A deficit in us trade implies that, the value of merchandise & services exported by
us is less than the value of merchandise & services that it imports.
 Negative Bop export > import: deficit.
B) Primary Income:
 It is mostly composed of income earned by multinational corporations on their
direct foreign investment (investment in fixed assets in foreign countries) and also
income earned by investors on portfolio investment.
 second component of current account
 Also called 'factor income'.
 Primary Income represents difference between primary income receipt and
payment.
 More suitable source of income.
 Voluntary
C) Secondary Income:
 Represents aid,grants and gift from one country tp another.
 Third component.
 Also called 'Transfer Payment'
 Represents how It's flow of fund with other countries is influenced by International
trade and income payment.
 Less suitable.
 Voluntary & involuntary both.

2) Financial Account:

The financial account measures the flow of funds between countries due to---

 Direct foreign investment

 Portfolio Investment
 Other Capital investment

 A positive number in the US financial account indicates payment representating

on DFI in the US; bez funds. US are flowing into the
 Converse payments representing us' based on multinational Corporation's direct
foreign in another country are recorded are a negative number bez funds. are
being sent from the us to another country.

 Portfolio investment:

This is the financial account that keeps track of a country's portfolio

investment, such as buying and selling stocks and bonds. Outflows are negative
for the financial account, while inflows are positive.
  Other capital investment:

This refers to transactions involving short-term financial assets between countries, such as
money market securities.

3) Capital account: This measures the flow of funds between one country and
all other countries due to financial asset transfers across country borders. This can
be due to people moving to a different country or the sale of patents and
trademarkers.

 However, some potential benefits include:

 Higher returns:

Investors may be able to earn higher returns on their investments in foreign

countries than they could in their home country.

 Diversification:

Investing in foreign assets can help to diversify an investment portfolio and

reduce risk.

 Exposure to different markets:

Investors can gain exposure to different markets and economies by investing

in foreign assets.

 Of course, there are also risks associated with investing in foreign countries, such
as:
 Currency risk:
The value of an investment can be affected by changes in currency
exchange rates.
 Political risk:
Political instability in a foreign country can lead to losses for investors.
 Economic risk:
A weak economy in a foreign country can also lead to losses for investors.
  Difference between 3 accounts :

Errors , Omissions & reserve:

It is a category in the balance of payments account that capture the difference

between the total value of credits (inflows) and debits (outflows). This discrepancy can
arise from incomplete data, unrecorded transactions, or valuation errors.

 Reserve: These are assets held by a country's central bank in foreign currencies
and gold.

A country with a negative current account balance has a positive capital & financial
account balance. This means that it sends more money out of the country than it receives
from other countries for trade and factor income. On the other hand, it receives more
money from other countries than it spends for capital and financial account transactions.

 Impact of outsourcing on trade:

The process of subcontracting to a 3rd party in another country to provide supplies or
services that were previously produced internally.
 Impact of outsourcing:
 Increased international trade
 Create jobs in developing countries
 Reduce cost of operation May reduce jobs in developed countries

 The impact of outsourcing on trade is complex and there are both positive and
negative effects. It is important to weigh these effects carefully when making
decisions about outsourcing.

 Factors affecting international trade flows: The most influential factors are:

(1) Cost of labor : Firms in countries where labor costs are low commonly
have an advantage when competing globally, especially in labor-intensive
industries. Higher labor costs can make a country's exports less competitive
and it can lead to decreased exports.
(2) Inflation:

Higher inflation makes exports more expensive and imports cheaper, reducing exports
and increasing imports. Lower inflation makes exports more competitive and imports
more expensive, increasing exports & reducing imports. Current account decreases if
inflation increases relative to trade partners.

(3) National income:

Current account decreases if country’s income level (NI) increases relative to other
countries.Lower income level leads to less spending potentially decreasing both exports
& imports.

(4) Credit conditions:

Credit conditions tend to tighten when economic conditions weaken as companies are
less able to repay debt.

These make banks less willing to lend money to companies which can reduce investment.

(5)Government Policies: Governments use various tools to influence trade and

promote domestic businesses, aiming for more exports and less imports.These tools
include:

 Restrictions on imports.
 Subsidies for exporters.
 Restrictions on foreign direct investment.
 Labor laws.
 Country-of-origin requirements.
 Government ownership & subsidies.
 Country-specific security requirements.
 Policies to punish foreign governments.

(6) Exchange rates:

Current account decreases if currency appreciates relative to other currencies.

 How exchange rate corrects a balance of trade deficit??

Ans: When a home currency exchanged for a foreign currency to buy foreign goods
then home currency faces downward pressure, leading to increased for the country's
product.
  Factors affecting direct foreign investment:

(1) Change in restrictions: ‘

Many countries are welcoming foreign investment. This has led to more investment in
developing countries, creating jobs & boosting economic growth.

(2) Privatization:

Governments are selling state-owned businesses to private investors. This can attract
foreign investment, increase competition, and improve efficiency.

(3)Potential economic growth:

Investors are drawn to countries with promising economic growth. Companies see these
markets as opportunities to expand their reach and make profits.

(4)Tax rates:

Countries with lower corporate tax rates are generally more attractive to foreign investors.
Lower taxes mean they get to keep more of their earnings, making the investment more
appealing.

(5)Exchange rates:

Exchange rates can play a role in how much foreign investment a country receives. A
strong currency can make it more expensive for foreign companies to invest, while a weak
currency can make it cheaper.

 Factors affecting portfolio investment:

a) Tax rate on interest and dividends:

Investors prefer countries with lower taxes on investment income, as this increases their
after-tax earnings.

b) Interest rates:

Investors are drawn to countries with high interest rates, as long as the local currency is
expected to remain stable. This is because they can earn higher returns on their
investment.

c) Exchange rate: Investors consider how changes in exchange rate will affect their
returns. If a country's currency is expected to strengthen,investors may be more willing to
invest in it’s securities to benifit from the currency movement. Conversely, if the currency
is expected to weaker,they may look elesewhere.
  Factors affecting international investment:
a) Tax rates on interest or dividends:
Investors prefer to invest in countries with lower taxes on interest or dividends.
b) Interest rates:
Investors tend to invest in countries with higher interest rates, as long as the local
currencies are not expected to weaken.
c) Exchange rates:
Investors may be willing to invest in a country's securities if its home currency is expected
to strengthen, and vice versa.

 Agencies that facilitate international trade and financial transactions:

1. International Monetary Fund (IMF):
The IMF is a multilateral organisation that Provides financial assistance to developing
Countries.The major objectives of the IMF, as set by its charter, are to:
 Promote cooperation among countries on international monetary issues
 Promote stability in exchange rates
 Provide temporary funds to member countries attempting to correct
imbalances of international payments
 Promote free mobility of capital funds across countries
 Promote free trade

2. World Bank:
The world bank is a group of five international organizations that Provide financing and
technical assistance to developing countries.
 The world Bank has been successful at reducing extreme poverty levels, increasing
education, preventing the spread of deadly diseases, and improving
environmental conditions. It also says that the World Bank's main source of funds
is the sale of bonds and other debt instruments to private investors.
 Structural Adjustment Loan (SAL), which is a type of loan that the World Bank
provides to countries to help them improve their long-term economic growth. The
text also discusses how the World Bank cofinances projects with other
development agencies, export credit agencies, and commercial banks.
Objectives: To reduce poverty, economic growth, improve living standards in developing
countries.
3. World Trade organization (WTO):
The WTO is an intergovernmental organisation that regulates international trade
Objectives :
To promote free trade,reduce trade barriers, settle trade disputes between member
countries.
4. International Finance Corporation ( IFC):
The IFC is a member of the world Bank Group that provides financing and advisory
services to private businesses in developing countries.
Objectives :To promote sustainable economic development, create jobs.
5.International Development Association (IDA):
The IDA is a member of the world Bank Group that provides concessional loans and
grants to the World's poorest countries.
Objectives :
promote economic growth, reduce poverty.
6. Bank for international settlements( BIS):
The BIS is an international organisation that promotes cooperation among central banks.
Objectives:
promote financial stability and cooperation among central banks.
The Organisation for Economic Co-operation and Development (OECD):
An intergovernmental organization with 38 member countries that aims to stimulate
economic progress and world trade.It Promotes policies that improve the economic and
social well-being of people around the world. This includes sharing best practices, setting
standards, and collecting data on a wide range of issues, including:
 Economic growth
 Education
 Environment
 Science and technology
 Taxation
 Trade
 How does it work?
 The OECD is governed by its member countries, which meet regularly to discuss
and agree on policies.
 The organization has a secretariat of experts who carry out research and analysis,
and provide support to member countries.
 The OECD also works with non-member countries and other international
organizations.
  Other organizations are:
Inter-American Development Bank (IDB):
Focuses on improving lives in Latin America and the Caribbean through financing,
knowledge, and policy dialogue.

 Asian Development Bank (ADB):

Promotes economic development in Asia through investments, policy advice, and
technical assistance.

 African Development Bank (ADB):

Works to reduce poverty and improve living standards in Africa by providing
financial and technical assistance for development project.

 Balance of payments accounting principle :

Balance of payments accounting principles, which are a set of rules used to record
international financial transactions. These rules ensure that all transactions are
recorded twice, once as a credit and once as a debit, so the total value of credits equals
the total value of debits.Here are the key points:
 Credits: Represent receiving payments from foreigners, like exports and
financial inflows.
 Debits: Represent making payments to foreigners, like imports.
 Double -entry bookkeeping.
Double-entry bookkeeping is an accounting method where every transaction is recorded
twice, once as a credit and once as a debit of an equal amount. This is done because every
transaction has two sides: something is given up and something is received.

For example, if a company sells a product for $100, it would credit its sales account for
$100 and debit its accounts receivable account for $100. The accounts receivable account
represents the money that the company is owed by the customer. Once the customer
pays the bill, the company would debit its accounts receivable account for $100 and
credit its cash account for $100.

Double-entry bookkeeping helps to ensure that the accounting records are accurate and
complete. It also makes it easier to track the financial performance of a business.

 Regional development agencies :

An agency whose objectives relate to economic development. These include the Inter-
American Development Bank, the Asian Development Bank, and the African
Development Bank. The European Bank for Reconstruction and Development was
created in 1990 to help Eastern European countries adjust from communism to
capitalism.
 3 Foreign Exchange Market
----------------------------------------------------------------------------------------------------------------

 Foreign Exchange Market

Definition: The Foreign Exchange Market (forex, FX) is a global marketplace where
currencies are bought, sold, and exchanged. It allows individuals and companies to
convert one currency to another for various purposes like international trade, travel, or
speculation.

Key points :

 Decentralized: Unlike traditional stock exchanges, the forex market has no

central location and operates through a network of banks and financial
institutions.
 Over-the-counter (OTC): Transactions happen directly between two parties,
not through a central exchange.
 Largest financial market: With trillions of dollars traded daily, it's the largest and
most liquid financial market globally.
 Exchange rates: The market determines the exchange rate, which is the price of
one currency in terms of another.
 Key participants: Banks, MNCs, individuals, financial institutions, and speculators
all participate in the market.
 Reasons to exchange currencies:
o International trade: Businesses import and export goods and services,
requiring currency exchange for payments.
o Travel: Tourists need local currency for their destinations.
o Investment: Speculators buy and sell currencies hoping to profit from
exchange rate fluctuations.
  Benefits: Facilitates international trade and investment, enables travel, and
provides opportunities for financial speculation.

Examples:

 A US company buying supplies in Mexico might exchange USD for MXN.

 A traveler going to Japan might exchange USD for JPY.
 A speculator might buy EUR hoping it will appreciate against USD.

 Exchange Rate:

An exchange rate is the price of one currency in terms of another currency. It tells you
how much of one currency you need to buy one unit of another currency.

Key Points:

 Two-way street: There's an exchange rate for every pair of currencies (USD to
EUR, EUR to JPY, etc.).
 Price tag: It's like a price tag for a currency, showing how much it costs in another
currency.
 Impacts costs: Affects the cost of goods and services when bought with different
currencies (e.g., your Mexican hotel).
 MNCs affected: Important for multinational companies dealing with invoices in
different currencies.
 Fluctuates: Exchange rates constantly change based on supply and demand,
global events, and other factors.

 History of Foreign Exchange

The system for establishing exchange rates has changed over time. It has evolved from
the gold standard to an agreement on fixed exchange rates to a floating rate system
1.Gold Standard 2. Agreements on Fixed Exchange Rates 3. Floating Exchange Rate
System
1. Gold Standard (1876-1914):

 Each currency was directly linked to gold, with a fixed exchange rate based on its
gold content.
 This system provided stability and predictability, but limited flexibility and was
vulnerable to disruptions like war.
 Ended with World War I.

2. Fixed Exchange Rates (1944-1971):

 The Bretton Woods Agreement established fixed exchange rates between major
currencies, with the US dollar as the anchor.
 This system aimed for stability and facilitated international trade, but it also led to
imbalances and eventually collapsed.

3. Floating Exchange Rate System (1971-present):

 Exchange rates are determined by supply and demand in the market, with central
banks occasionally intervening to influence volatility.
 This system offers more flexibility but can be more volatile and unpredictable.

Additional Points:

 The Smithsonian Agreement (1971) attempted to adjust the Bretton Woods system
before its collapse.
 Some countries still maintain fixed or semi-fixed exchange rates, while others allow
their currencies to float freely.
 Central banks sometimes still intervene in the foreign exchange market to
influence exchange rates or reduce volatility.
 Some countries still use fixed exchange rate systems, often pegged to a major
currency like the US dollar.

Overall, the history of foreign exchange reveals a constant evolution in response to

changing economic and political conditions.
  Foreign Exchange Transactions

Definition: Foreign exchange transactions involve the buying and selling of different
currencies. This market is not a physical location, but rather a network of banks and
financial institutions that trade currencies electronically.

Key points:

 Decentralized: No central location, it operates through a network of institutions.

 Over-the-counter (OTC): Transactions happen directly between participants,
not on a centralized exchange.
 Major trading centers: London (33% volume) and New York City (20% volume)
dominate, but trading happens globally.
 Types of transactions:
o Banks and customers (buying/selling currencies)
o Interbank dealings within a market
o Interbank dealings between markets
o Transactions between central banks within a country
o Transactions between central banks of different countries

Additional points:

 The foreign exchange market is the largest financial market in the world, with daily
trading volume exceeding $7.5 trillion.
 Exchange rates are determined by supply and demand, influenced by economic
factors and central bank policies.
 Foreign exchange transactions are crucial for international trade and investment.
  Foreign Exchange Dealers:

Definition

 Intermediaries in the foreign exchange market who facilitate currency exchange

for individuals and companies (MNCs).

Examples

 Large commercial banks (Citigroup, JPMorgan Chase, Barclays, UBS, Deutsche

Bank) with physical branches and online platforms.
 Online-only dealers (FX Connect, OANDA, XE.com).

How They Work

 Customers create online accounts and place orders through the dealer's website.
 New platforms allow MNCs to trade directly with each other, bypassing dealers.

Who Uses Them?

 MNCs and individuals needing to exchange currencies.

 MNCs may prefer personalized service or custom transactions offered by dealers.

Trends

 Shift towards online trading and direct trading platforms for MNCs.
 Traditional dealers still relevant for personalized service and complex transactions.

Benefits of using Foreign Exchange Dealers

 Convenience: online trading platforms and physical branches offer easy access.
 Expertise: dealers have knowledge and experience in currency markets.
 Security: regulated entities with security measures in place.
 Customization: some dealers offer personalized service and tailored solutions.
Drawbacks of using Foreign Exchange Dealers

 Fees: dealers charge commissions or spreads on transactions.

 Limited options: traditional dealers may not offer all currencies or trading
platforms.
 Competition: new platforms offer lower fees and direct access to other MNCs.

 Spot Market:

Definition:

 A market where currencies are exchanged for immediate delivery (usually within
two business days).
 Also known as the cash market or foreign exchange market (forex market).

Key characteristics:

 Immediate delivery: Unlike futures markets where delivery happens later, spot
market trades are settled quickly, usually within two days.
 Price determination: The exchange rate is determined by supply and demand of
currencies.
 Trading platform: Transactions can occur electronically through banks, financial
institutions, or on exchanges.
 Interbank market: Banks trade currencies among themselves to manage their
foreign exchange positions.

Additional points:

 Spot rates are constantly fluctuating based on various factors like economic data,
news, and market sentiment.
 Businesses use the spot market to settle international trade and payments.
 Individuals use the spot market for currency exchange when traveling or for
investment purposes.
  Spot market liquidity
Spot market liquidity is the ease with which a currency can be bought or sold at the
prevailing market price. It is determined by the level of trading activity in the spot market
for that currency. The more buyers and sellers there are, the more liquid the market is.

Key points about spot market liquidity:

Affects how easily a currency can be bought or sold:
A liquid currency can be bought or sold quickly and easily, with minimal impact on the
price. An illiquid currency may be difficult to buy or sell, and the price may be more
volatile.

More buyers and sellers lead to more liquidity:

The more participants there are in a market, the easier it is to find a buyer or seller for a
currency. This increases liquidity and reduces the bid-ask spread.

Highly traded currencies are very liquid:

The spot markets for major currencies such as the US dollar, euro, and Japanese yen are
very liquid, due to the high volume of trading activity.

Less developed countries' currencies are less liquid:

The spot markets for currencies of less developed countries are often less liquid, due to
lower trading volumes and fewer market participants.

Illiquid currencies can be difficult to buy or sell at a reasonable rate:

If a currency is illiquid, there may be few buyers or sellers willing to trade at the prevailing
market price. This can make it difficult to buy or sell the currency at a reasonable rate

 Attributes of Banks That Provide Foreign Exchange

When choosing a bank for foreign exchange, companies should consider the following:

Price:
Getting a good exchange rate is important, even small differences can add up to
significant savings.

Relationship:
A good relationship with the bank can get you better rates, access to harder-to-find
currencies, and other helpful services.
Speed: How quickly the bank can process your transaction is important, especially if you
need the currency urgently.

Market information: Some banks offer valuable insights into current market conditions
and foreign economies.

Forecasting: Some banks can provide forecasts about future exchange rates, which can
help you make informed decisions

 Bid/Ask Spread of Banks

The bid/ask spread is the difference between the price a bank is willing to buy a currency
(bid price) and the price it's willing to sell it (ask price). It signifies the bank's profit from
facilitating foreign exchange transactions.
Key Points:

Higher cost for customers: A wider spread means a higher cost for individuals and
companies exchanging currencies.

Bank's revenue: Wider spreads generate more income for banks.

Expressed as a percentage: It's typically shown as a percentage of the ask price.
Example: For the British pound, the spread is $0.08, or 5% of the ask price ($1.60).
Another Example :
British pound: Spread is 5%, indicating a higher cost compared to the Japanese yen's
0.054% spread.

Japanese yen: Smaller spread suggests a lower transaction cost for customers.
Remember:
A tighter spread often signifies a more competitive market with lower transaction costs.
Compare spreads across different banks to find the most favorable exchange rate
Factors That Affect the Spread
The spread on currency quotations is influenced by the following factors:
Spread= f (Order costs, Inventory costs, Competition, Volume, Currency risk)

Order costs:
Order costs are the costs of processing orders, these costs include clearing costs and the
costs of recording transactions.

Inventory costs:
Inventory costs are the costs of maintaining an inventory of a particular currency. Holding
an inventory involves an opportunity cost because the funds could have been used for
some other purpose. If interest rates are relatively high, then the opportunity cost of
holding an inventory should be relatively high. The higher the inventory costs, the larger
the spread that will be established to cover these costs

Volume:
Currencies that are more liquid are less likely to experience a sudden change in price.
Currencies that have a large trading volume are more liquid because there are numerous
buyers and sellers at any given time. This means that the market has enough depth that
a few large transactions are unlikely to cause the currency's price to change abruptly.

Competition:
The more intense the competition, the smaller the spread quoted by intermediaries.
Competition is more intense for the more widely traded currencies because there is more
business in those currencies. The establishment of trading platforms that allow MNCs to
trade directly with each other is a form of competition against foreign exchange dealers,
and it has forced dealers to reduce their spread in order to remain competitive.

Currency risk :
Some currencies exhibit more volatility than others because of economic or political
conditions that cause the demand for and supply of the currency to change abruptly.
For example, currencies in countries that have frequent political crises are subject to
sudden price movements. Intermediaries that are willing to buy or sell these currencies
could incur large losses due to such changes in their value
 Here is a table that summarizes the key points:

Factor Description Impact on spread

Order costs The costs of processing Higher order costs lead to a wider spread.
orders

Inventory costs The costs of holding onto a Higher inventory costs lead to a wider
currency spread.

Volume How much of a currency is Higher volume leads to a narrower spread.

being traded

Competition The number of dealers More competition leads to a narrower

offering to buy and sell a spread.
currency

Currency risk The risk that the value of a Higher currency risk leads to a wider
currency will change spread.
suddenly

 Foreign Exchange Quotations:

Definition:
Foreign exchange quotations are the published prices at which currencies can be bought
and sold. They indicate how much of one currency you need to exchange for one unit of
another currency.
Key Points:

Readily available online:

Quotes for various currencies can easily be found on financial websites, news
websites, and dedicated foreign exchange platforms.

Frequent updates:
Quotes are dynamically updated throughout the day to reflect changes in the market.

Similar across banks:

At any given time, quotes should be relatively consistent across different banks offering
foreign exchange services.
Market forces lead to consistency:
Large discrepancies incentivize arbitrage (buying low and selling high), which pressures
banks to align their quotes.

Quotes influence transactions:

Individuals and businesses use quotes to decide when and where to exchange
currencies.

Additional notes:
Quotes can be direct (price of foreign currency in domestic currency) or indirect (price of
domestic currency in foreign currency).
Factors like economic news, interest rates, and political events can impact exchange rates
and quotes.
Understanding quotes is crucial for making informed decisions in foreign exchange
transactions

 Direct vs. Indirect Quotations in Currency Exchange Rates:

Direct quotation:

 Tells you how many dollars you need to buy one unit of another currency.
 Usually displayed as number of dollars per foreign currency unit.
 Example: 1 € = $1.25 (means $1.25 buys 1 euro)

Indirect quotation:

 Tells you how many units of a foreign currency you get for one dollar.
 Usually displayed as number of foreign currency units per dollar.
 Example: 0.8 €/$1 (means $1 buys 0.8 euros)

Key points:

 Direct and indirect quotations are two ways to express the same exchange rate.
 Indirect quotation is the reciprocal of the direct quotation.
 Websites often allow switching between direct and indirect quotes.
Remember:

 Direct quotation tells you how many dollars you need.

 Indirect quotation tells you how much foreign currency you get for a dollar

Functions of Foreign Exchange market

 Cross Exchange Rates:

Definition:
An exchange rate between two non-dollar currencies.
It directly compares the value of one foreign currency to another, without using the US
dollar as an intermediary.

Example:
 A US company holds Canadian dollars but needs Mexican pesos.
 The cross exchange rate tells them how many pesos they'll get for their Canadian
dollars.

Importance:
 Useful for companies and individuals dealing with multiple foreign currencies.
 Simplifies international transactions and avoids extra conversion steps.
 Can be used for investment strategies and currency arbitrage.

Calculation:
Involves two currency conversions:
 Convert currency 1 to USD.
 Convert USD to currency 2.
Can be derived from existing USD exchange rates for both currencies.

Finding cross exchange rates:

 Available online on financial websites and currency converters.
 May be less readily available than USD-based rates.
Additional notes:
 Cross rates are constantly fluctuating due to market forces.
 Always ensure you're using the most up-to-date rates for accurate calculations.

 The foreign exchange market in Bangladesh

The foreign exchange market in Bangladesh is a system where Bangladeshi Taka (BDT) is
exchanged for other foreign currencies, such as the US dollar (USD), euro (EUR), and
Japanese yen (JPY). It is an essential part of the Bangladeshi economy, as it facilitates
international trade and investment.

Key points about the foreign exchange market in Bangladesh:

Underdeveloped:
Compared to developed economies, the foreign exchange market in Bangladesh is still
relatively small and less sophisticated.

No central exchange:
Unlike stock exchanges, there is no single physical location where foreign exchange
transactions take place.

Three-tiered market:
The market is divided into three tiers:

Tier 1: Bangladesh Bank and authorized dealers

Tier 2: Banks and their foreign correspondents and branches
Tier 3: Banks and their customers
Broker-driven:
Transactions are typically conducted through brokers, who match buyers and sellers of
foreign currency.

Private negotiation:
Some foreign exchange transactions also occur through private negotiation between
individuals or businesses.
The importance of the foreign exchange market in Bangladesh:
Facilitates international trade:
Businesses need to convert BDT into foreign currencies to import goods and services, and
foreign currencies into BDT to export goods and services.

Enables foreign investment:

Foreign investors need to convert their currencies into BDT to invest in Bangladesh.

Provides a source of foreign exchange:

Bangladeshis working abroad send remittances back home in foreign currencies, which
are then converted into BDT.
Challenges facing the foreign exchange market in Bangladesh:

Limited market depth:

The small size of the market can make it difficult to find buyers and sellers for certain
currencies.

Volatility:
The exchange rate can be volatile, which can create uncertainty for businesses and
investors.

Informal market:
A significant portion of foreign exchange transactions take place in the informal
market, which is difficult to regulate.

The future of the foreign exchange market in Bangladesh:

The government of Bangladesh is taking steps to develop the foreign exchange market,
such as by:

Liberalizing the market:

Reducing restrictions on foreign exchange transactions.

Promoting market competition:

Encouraging more banks and other financial institutions to participate in the market.

Improving market infrastructure:

Developing electronic trading platforms and other technologies.
These measures are expected to help make the foreign exchange market in Bangladesh
more efficient, transparent, and competitive
  Participants of Foreign Exchange Markets"

Participants of Foreign Exchange Markets

The foreign exchange market, also known as forex, is a global marketplace where
currencies are traded. Participants in the foreign exchange market can be broadly
categorized into four groups:

1. Non-bank entities:

These are individuals or businesses that need to exchange currencies for various
reasons, such as to pay for imports or exports, travel, or investment.

2. Banks:

Banks play a key role in the foreign exchange market by facilitating currency
exchange for their clients. They also trade currencies on their own account to
speculate on price movements or to hedge their positions.

3. Speculators:

Speculators are individuals or businesses that buy and sell currencies in the hope
of making a profit from changes in their prices. Speculators may use fundamental
analysis, technical analysis, or a combination of both to make their trading
decisions.

4. Arbitrageurs:

Arbitrageurs are individuals or businesses that exploit price discrepancies between

different markets to make risk-free profits. In the foreign exchange market,
arbitrageurs may buy a currency in one market and sell it simultaneously in another
market where the price is higher

 Derivative Contracts in the Foreign Exchange Market

A currency derivative is a contract with a price that is partially derived from the value of
the underlying currency that it represents.
Three types of currency derivatives that are often used by MNCs are forward contracts,
currency futures contracts, and currency options contracts. Each of these currency
derivatives will be explained in the following:
2. Types:
Forward Contracts:
Lock in an exchange rate for future transactions, often used for hedging payables or
receivables.

Currency Futures Contracts:

Standardized contracts traded on exchanges, similar to forward contracts.

Currency Options Contracts:

Give the right, but not obligation, to buy or sell a currency at a specific price by a certain
date. Can be calls (buy) or puts (sell).

3. Benefits:
Hedge against currency fluctuations:
Protect against unexpected changes in exchange rates.

Plan future transactions:

Lock in exchange rates for budgeting and forecasting purposes.

Manage risk exposure:

Reduce uncertainty and improve financial stability.

4. Examples:
 Memphis Co. uses a forward contract to hedge euro payments and a forward
contract to hedge peso receivables.
 Google uses forward contracts worth over $1 billion for hedging.
 The Coca-Cola Co. uses currency options contracts for hedging.

5. Important notes:
 Forward and futures rates are fixed, while future spot rate is unknown today.
 Options offer flexibility but come with a premium cost.

Additional points:
 Forward market is over-the-counter, futures market is on exchanges.
 Futures rate and forward rate lock in exchange rate, but differ in contract details.
 Future spot rate is unknown, but hedging with futures/forwards can be beneficial
if expected to be higher than futures/forward rate.
 Derivatives can be complex instruments and carry risks.
  Understanding your risk tolerance and consulting a financial professional is crucial
before using them.

Functions of the Foreign Exchange Market:

 Transfer of funds and currency:

 This is the main function of the Foreign Exchange Market, which allows for the
exchange of currencies between different countries. Most of these transactions
take place electronically, rather than through physical exchanges of cash.
 The Foreign Exchange Market also provides credit to businesses
engaged in international trade.
 This is necessary because there is often a time lag between when goods are
exported and when payment is received. Exporters can sell their bills of exchange
to banks at a discount, in order to receive payment immediately.

The Foreign Exchange Market is an essential part of the global economy, and it plays a
vital role in facilitating international trade and investment.

International Money Market

Definition:

 A global marketplace for short-term borrowing and lending in various currencies.

 Connects surplus units (with extra funds) to deficit units (needing funds)
internationally.
 Facilitates international trade and financial activities of multinational companies
(MNCs).

Key Points:

 Purpose:
o MNCs borrow short-term funds in different currencies to pay for imports.
o MNCs borrow in currencies with lower interest rates for local operations.
o MNCs borrow in currencies expected to depreciate against their home
currency for cheaper repayment.
 Participants:
o Surplus units (individuals/institutions with extra funds).
 o Deficit units (individuals/institutions needing funds).
o Financial institutions (banks, dealers) accept deposits and provide loans in
various currencies.
 Benefits:
o Enables efficient international trade and financial activities.
o Provides MNCs with flexible funding options in various currencies.
o Helps manage foreign exchange risks.

Additional Notes:

 Interest rates in the international money market vary based on currency and
creditworthiness of borrowers.
 Foreign exchange rates play a crucial role in determining the cost of borrowing in
different currencies.
 The International Monetary Market (IMM) is a specific exchange platform for
trading currency futures and options.

 European and Asian Money Markets:

Definition:
Financial centers specializing in short-term borrowing and lending (up to 1 year), mainly
for international transactions.
Developed in the 1970s to service multinational corporations (MNCs) expanding
overseas.

Origins:
European Money Market:
 Driven by demand for US dollars (Eurodollars) for international trade and OPEC oil
sales.
 US corporations deposited dollars in European banks, who then lent them to
European businesses.

Asian Money Market:

 Emerged to serve businesses using US dollars for trade in Asia, independent of
European markets.
 A market for short-term deposits and loans in various currencies, primarily centered
in Hong Kong and Singapore
Key Features:
 Mainly deal in short-term instruments like certificates of deposit (CDs) and
commercial paper.
 Offer competitive interest rates due to high liquidity and low credit risk.
 Play a crucial role in facilitating international trade and investment.

Additional Notes:
 The terms "Eurodollar" and "petrodollar" refer to specific types of dollar-
denominated deposits in the European and Asian money markets, respectively.
 Eurodollar market: A market for short-term U.S. dollar deposits and loans outside
the United States.
 Petrodollars: U.S. dollars earned by oil-exporting countries, often deposited in
European banks.
 Both markets have evolved beyond just US dollars and now deal in various foreign
currencies

LIBOR
LIBOR stands for London Interbank Offered Rate. It is the average interest rate at which
major banks in London are willing to lend short-term funds to other banks. LIBOR is a
benchmark interest rate that is used to set the interest rates on a variety of financial
products, including adjustable-rate mortgages, student loans, and credit cards.

How LIBOR works:

 Each day, a panel of banks submits estimates of the interest rate at which they
would be willing to lend money to other banks.
 These estimates are averaged to create a LIBOR rate for different maturities, such
as overnight, one month, three months, and six months.
 The LIBOR rate is then published by a financial data provider, such as Bloomberg
or Reuters.

The impact of LIBOR:

 LIBOR is a key indicator of the health of the global financial system.
 When LIBOR rises, it can signal that banks are becoming more risk-averse and are
less willing to lend money.
 This can lead to higher interest rates for borrowers and slower economic growth.
LIBOR is being phased out:
 In the wake of the financial crisis of 2008, it was revealed that some banks had
manipulated LIBOR.
  As a result, LIBOR is being phased out and replaced by alternative benchmark
rates, such as the Secured Overnight Financing Rate (SOFR) in the United States.

International Credit Market

Imagine a company needs a loan for a few years. They can borrow from local banks or
issue notes in their home country (domestic market). But there's another option:
borrowing from foreign banks. This is the international credit market.

Key players:

 Multinational corporations (MNCs): Big companies operating in many countries.

 Banks: Located in different countries, offering loans in various currencies.
 Investors: Lend money to borrowers through banks or by buying notes.

Types of loans:

 Term loans: Fixed amount borrowed for a set period (e.g., 5 years).
 Notes: Similar to bonds, issued by companies to raise funds.

Example:

 A US company needs a loan for a new factory in Europe.

 They can borrow Euros from a bank in London.
 This loan is called a Euro credit, part of the Euro credit market.

Benefits:

 Access to more lenders and competitive rates.

 Borrow in different currencies to manage risk.

Risks:

 Currency fluctuations can affect loan value.

 Foreign regulations and legal systems add complexity
Remember:

 International credit market connects borrowers and lenders across borders.

 Euro credits are loans to MNCs or governments in Europe, typically in Euros.
 It's an option for companies seeking medium-term funds beyond their home
market

 syndicated loans in the credit market

What are syndicated loans?

A syndicated loan is a loan that is provided by a group of lenders, rather than a single
lender. This is typically done when the loan amount is too large for a single lender to
provide on its own. The lenders in the syndicate share the risk of the loan, and each lender
contributes a portion of the total loan amount.

Key points about syndicated loans:

 They are used to finance large loans that a single lender cannot provide on its own.
 The lenders in the syndicate share the risk of the loan.
 They can be denominated in a variety of currencies.
 The interest rate depends on the currency, maturity, and creditworthiness of the
borrower.
 The interest rate is usually adjusted to reflect changes in market interest rates.

Here are some additional details about syndicated loans:

 The lead bank is responsible for negotiating the terms of the loan with the
borrower and organizing the syndicate of lenders.
 Each lender in the syndicate has a participation agreement that outlines their
commitment to the loan.
 Syndicated loans can be complex and can involve a variety of different terms and
conditions.
  International bond market

The international bond market is a global marketplace where borrowers and lenders from
different countries can trade debt securities. It is a major source of long-term financing for
governments and corporations around the world.

Key points:

 Major investors: Institutional investors such as commercial banks, mutual

funds, insurance companies, and pension funds.
 Borrowers: National governments and multinational corporations (MNCs).
 Reasons for MNCs to issue bonds in the international bond market:
o Attract a stronger demand from foreign investors.
o Finance a specific foreign project in a particular currency.
o Finance projects in a foreign currency with a lower interest rate.

Additional notes:

 The international bond market is a complex and ever-evolving market.

 There are a variety of different types of international bonds, each with its own
unique risks and rewards.
 Investors should carefully consider their investment objectives and risk tolerance
before investing in international bonds.

Eurobond Market:

What is a Eurobond?

 A Bonds that is sold outside the issuer's home country, denominated in a foreign
currency (e.g., a US company issuing bonds in Euros).
 Think of it as "global borrowing" with wider reach and funding options.
 For example, a US company might issue a Eurobond denominated in euros.
 Imagine borrowing money in a foreign currency, but not just from one country.
That's essentially the Eurobond market!
Why are Eurobonds popular?

 They circumvent registration requirements and avoid some disclosure

requirements.
 This means that they can be issued quickly and at a low cost.
 They are underwritten by a multinational syndicate of investment banks and are
simultaneously placed in many countries, providing a wide spectrum of fund
sources to tap.

Who uses Eurobonds?

 US-based MNCs such as McDonald's and Walt Disney commonly issue Eurobonds.
 Non-US firms (e.g., Guinness, Nestlé, Volkswagen) also use the Eurobond market
as a source of funds.

Benefits of Eurobonds:

 Issuers can access a wider pool of investors.

 Investors can diversify their portfolios.
 Eurobonds can be a cheaper source of financing than issuing bonds in the issuer's
home country.

Drawbacks of Eurobonds:

 Issuers are exposed to currency risk.

 Eurobonds can be more complex to structure than domestic bonds

International stock markets:

What are international stock markets?
International stock markets are exchanges where stocks of companies from different
countries are bought and sold. Investors can purchase stocks in companies from all over
the world, giving them exposure to a wider range of industries and economies.

Why invest in international stock markets?

There are several reasons why investors might choose to invest in international stock
markets:
Diversification:
By investing in stocks from different countries, investors can reduce their overall portfolio
risk. This is because different countries have different economic cycles, so if one country's
economy is doing poorly, the stocks of companies in that country may fall in value, but
the stocks of companies in other countries may still perform well.

Growth potential:
Some countries have faster-growing economies than others, and so the stocks of
companies in those countries may have more growth potential.

Currency appreciation:
If an investor expects the currency of a particular country to appreciate, they can invest
in stocks in that country in order to profit from the currency appreciation.

How to invest in international stock markets:

There are a few different ways to invest in international stock markets:

Buy individual stocks:

Investors can buy individual stocks of companies from other countries. However, this can
be time-consuming and expensive, as investors need to research each company carefully
before investing.

Invest in mutual funds or ETFs:

Mutual funds and ETFs are investment vehicles that pool the money of many investors
and invest it in a basket of assets, such as stocks, bonds, or commodities. There are many
mutual funds and ETFs that invest in international stocks. This can be a more convenient
and affordable way to gain exposure to international markets.

Risks of investing in international stock markets:

There are some risks associated with investing in international stock markets, including:

Currency risk:
The value of an investor's investment can be affected by changes in exchange rates.

Political risk:
Political instability in a country can lead to a decline in the value of stocks in that country.

Economic risk:
A slowdown in the economy of a country can lead to a decline in the value of stocks in
that country.
International stock markets can be a good way for investors to diversify their portfolios
and gain exposure to growth potential. However, it is important to be aware of the risks
involved before investing

How Governance Varies among Stock Markets

Strong governance is linked to higher stock market participation and activity. Here are
some key factors that contribute to strong governance:

1. Shareholder Rights:
Voting Power:
Some countries grant shareholders more voting power on company issues.
Influence: Shareholders might have greater influence over management decisions in
certain countries.

2. Legal Protection:
Lawsuits: Shareholders in certain countries, especially common-law countries, have more
legal options to sue for financial fraud.

3. Government Enforcement:
Effective Laws: Strong enforcement of existing laws protecting shareholders is crucial.
Corruption Control: Countries with less corporate corruption offer better protection for
shareholder interests.

4. Accounting Standards:
International Rules: The International Accounting Standards Board (IASB) promotes
uniformity in financial reporting.
Transparency: Clear and transparent financial reporting reduces information gaps for
shareholders.

Overall:
 Strong governance fosters trust and transparency, attracting more investment and
trading activity in a stock market.
 Differences exist between countries in terms of shareholder rights, legal protection,
enforcement, and accounting standards.
 Understanding these variations is crucial for informed investment decisions across
international markets.
  Impact of Governance Characteristics on Stock Markets:

Concept: Strong governance characteristics in a stock market attract more investors,

leading to:

 Increased investor confidence: Investors feel safer due to factors like shareholder
rights, legal protection, law enforcement, and transparent accounting.
 Greater pricing efficiency: Many investors constantly monitor companies, ensuring
accurate stock prices.

Negative consequences of weak governance:

 Low investor attraction: Investors hesitate to invest, hindering capital flow.

 Limited company options: Businesses struggle to find funding, potentially relying
on foreign markets or debt.

Key characteristics for strong governance:

 Strong shareholder rights: Clear voting rights and influence for investors.
 Robust legal protection: Laws safeguarding investments and property rights.
 Effective law enforcement: Consistent application of laws to ensure fairness and
trust.
 Strict accounting standards: Transparent and reliable financial reporting by
companies

Risk of International Bonds From the perspective of investors

International bonds are subject to four forms of risk: interest rate risk, exchange rate risk,
liquidity risk, and credit (default) risk

Interest rate risk:

 The risk that the value of a bond will decline if interest rates rise.
 This is because investors will require a higher return on their investments, and so
the price of existing bonds will have to fall to make their yields more attractive.
 Fixed-rate bonds are more susceptible to interest rate risk than floating-rate bonds,
because their coupon payments do not change even if interest rates rise.
  Example: If you buy a 10-year bond with a 5% coupon rate and interest rates rise
to 7%, the price of your bond will fall.

Exchange rate risk:

 The risk that the value of a bond will decline if the currency in which it is
denominated depreciates against the investor's home currency.
 This is because the investor will receive fewer units of their home currency when
they convert the bond's coupon and principal payments.
 Example: If you buy a bond denominated in euros and the euro weakens against
the dollar, the value of your bond will decline in dollar terms

Liquidity risk:

 The risk that an investor will have difficulty selling a bond at a fair price.
 This can be a problem for international bonds, especially those issued by smaller
or less well-known companies or governments.
 Example: You may have difficulty selling a bond issued by a small company or
government, even if it is creditworthy.

Credit risk:

 The risk that the issuer of a bond will default on their debt, meaning that they will
not make their coupon or principal payments.
 This risk is generally higher for international bonds than for domestic bonds,
because investors may have less recourse if the issuer defaults.
 Example: If the company or government that issued the bond goes bankrupt, you
may lose all or part of your investment

Exchange Rate Systems:

An exchange rate system is basically a set of rules that govern how a country's currency
value is determined against other currencies. There are four main types:

1. Fixed: The government sets a fixed exchange rate, meaning the value of their
currency is pegged to another currency (like the US dollar) or a basket of currencies. This
creates stability and predictability for businesses and trade, but it limits the government's
ability to control inflation and respond to economic changes.
2. Freely Floating:

The exchange rate is determined by supply and demand in the foreign exchange market,
just like the price of any other good or service. This can be more flexible and responsive
to economic changes, but it can also be more volatile and unpredictable.

3. Managed Float:

This is a mix of fixed and floating systems. The government intervenes in the market to
buy or sell their currency to keep it within a certain target range. This aims to balance
stability with some flexibility.

4. Pegged:

Similar to fixed, but instead of pegging to a single currency, it's pegged to a basket of
currencies, which can provide some flexibility while still offering stability.

Fixed Exchange Rate System:

Definition:

A system where a government or central bank maintains a fixed exchange rate for its
currency against another currency, a basket of currencies, or another measure like gold.
This means the exchange rate only fluctuates within a narrow band.

Key points:

 Stability: Provides stability and predictability for businesses and individuals

involved in international trade and finance.
 Central bank intervention: Requires central bank intervention to buy or sell its
own currency to maintain the fixed rate.
 Devaluation & revaluation: Central bank can devalue (decrease) or revalue
(increase) the currency's value within the system.
 Limited flexibility: Limits the central bank's ability to use interest rates to manage
inflation or economic growth.
 Rarely used: Most major economies use floating exchange rate systems where
market forces determine the exchange rate.
Additional points:

 Depreciation and appreciation are typically used for floating exchange rates,
where the currency's value can fluctuate freely.
 Fixed exchange rates can be beneficial for small, open economies that rely heavily
on trade.
 However, they can also be risky if the central bank cannot maintain the fixed rate,
leading to speculative attacks and currency crises.

Bretton Woods Agreement (1944-1971):

Fixed exchange rates:

Currencies were pegged to the US dollar, which in turn was pegged to gold at a rate of
$35 per ounce.

 Goal: Promote global economic stability and trade after WWII.

 Key features:
o Each currency had a fixed "par value" against the US dollar.
o Governments intervened in markets to maintain exchange rates within 1%
of par value.
o Created the International Monetary Fund (IMF) to monitor exchange rates
and provide financial assistance to countries facing balance of payments
issues.
o Created the World Bank to provide financial assistance for reconstruction
and development.
 Challenges:
o US dollar deficits put pressure on the system.
o Fixed rates became inflexible as economies grew at different rates.

Smithsonian Agreement (1971-1973):

 Attempt to reform Bretton Woods: Devalued the US dollar by 8% and widened

allowable exchange rate bands to 2.25%.
 Short-lived success: US deficits and economic imbalances persisted.
 Outcome: Ended in 1973 as major countries abandoned fixed exchange rates,
marking the end of the Bretton Woods era.
Additional Notes:

 The Bretton Woods era is important for understanding the development of the
global financial system.
 The collapse of fixed exchange rates led to the current floating exchange rate
system.

Advantages of Fixed Exchange Rates:

 Reduced exchange rate risk: Businesses and investors can plan better
knowing the fixed exchange rate, eliminating concerns about currency
fluctuations.
 Stable investment environment: Fixed exchange rates can attract foreign
investment by offering stability and predictability.
 Lower transaction costs: Businesses involved in international trade can avoid
costs associated with hedging against currency fluctuations.
 Potential for lower inflation: Fixed exchange rates can help control inflation
by tying the domestic currency to a stable foreign currency.

Disadvantages of Fixed Exchange Rates:

 Limited monetary policy flexibility: Central banks lose the ability to use
interest rates to manage domestic economic conditions.
 Speculative attacks: If investors lose confidence in the fixed rate, they may try to
sell the currency, putting pressure on the central bank to devalue.
 Capital controls may be needed: To defend the fixed rate, countries may need
to restrict capital inflows and outflows, hindering economic growth.
 Reduced competitiveness: Overvalued currencies can make exports less
competitive and imports cheaper, harming domestic industries.
Key Points:

 Fixed exchange rates offer stability and predictability but limit central bank
flexibility.
 They can benefit trade and investment but may require capital controls.
 They can make economies more vulnerable to external shocks.
Freely Floating Exchange Rate System:
A freely floating exchange rate system is one where the value of a currency is determined
solely by market forces, meaning supply and demand, without any intervention from the
government. This stands in stark contrast to a fixed exchange rate system, where the
government actively manages the currency's value by pegging it to another currency or
a basket of currencies.

Here are the key points of a freely floating exchange rate system:
Market-driven:
The exchange rate fluctuates freely based on supply and demand for the currency in the
foreign exchange market.

Flexible:
There are no fixed upper or lower limits on the exchange rate, allowing it to move freely.

Continuous adjustment:
The exchange rate constantly adjusts in response to changes in supply and demand.

Limited government intervention:

Governments generally refrain from interfering in the market to influence the exchange
rate.

Potential for volatility:

The exchange rate can be unpredictable and prone to fluctuations, which can create
uncertainty for businesses and investors

Advantages of a Freely Floating Exchange Rate System:

Insulation from foreign inflation:
When a country experiences high inflation, its currency weakens, making its imports more
expensive and exports cheaper. This helps offset the domestic inflation for consumers and
businesses.

Insulation from foreign unemployment:

When a country experiences high unemployment, its currency weakens, making its
exports cheaper and imports more expensive. This helps boost exports and create jobs.
Policy independence
Governments can pursue domestic economic policies without worrying about their
impact on the exchange rate.

Disadvantages of a Freely Floating Exchange Rate System:

Exchange rate volatility:
Fluctuations in the exchange rate can create uncertainty for businesses and investors,
making it difficult to plan for the future.

Imported inflation:
A weakening currency can make imports more expensive, leading to higher domestic
inflation.

Reduced competitiveness:
A strong currency can make exports more expensive, making it harder for businesses to
compete in foreign markets.

Key Points:
 Freely floating exchange rates are determined by supply and demand in the
foreign exchange market.
 They offer advantages in terms of insulation from foreign economic shocks and
policy independence.
 However, they also come with disadvantages like exchange rate volatility and
potential for imported inflation

Managed Float Exchange Rate System

Definition: Currency value fluctuates based on supply and demand but with occasional
government intervention to achieve specific goals.

Key Features:

 Currency flexibility: Allows some natural adjustment in response to market

forces.
 Government intervention: Central bank can buy or sell currencies to influence
exchange rate.
 Goals: Maintain currency stability, manage inflation, promote exports, etc.
  Comparison to free float: More government control than a purely free-floating
system.
 Comparison to pegged system: More flexibility than a fixed exchange rate.

Examples: China, India, South Korea, Brazil

Types of Intervention:

 Buying/selling domestic currency: Raises/lowers value.

 Interest rate adjustments: Affect currency attractiveness.
 Verbal warnings: Can influence market sentiment.

Benefits:

 Flexibility: Adjusts to economic changes.

 Stability: Prevents large fluctuations.
 Control: Achieves specific economic goals.

Drawbacks:

 Uncertainty: Market participants unsure of future interventions.

 Manipulation: Potential for unfair advantage or currency wars.
 Transparency: Lack of clarity about intervention rules.

 Pegged Exchange Rate System

Definition: Currency value fixed to another currency or basket of currencies.

Some countries use a pegged exchange rate in which their home currency's value is
pegged to one foreign currency or to an index of currencies. Although the home
currency's value is fixed in terms of the foreign currency to which it is pegged, it moves in
line with that currency against other currencies. A government may peg its currency's
value to that of a stable currency, such as the dollar, because doing so stabilizes the value
of its own currency.

Key Features:

 Fixed exchange rate: Minimal fluctuation allowed.

  Stability: Predictable exchange rate for trade and investment.
 Central bank intervention: Maintains peg through buying/selling currencies.
 Loss of monetary policy autonomy: Limited ability to set interest rates
independently.

Examples: Hong Kong, Saudi Arabia, Panama

Benefits:

 Stability: Predictable costs for imports and exports.

 Confidence: Attracts foreign investment.
 Inflation control: Can import price stability from anchor currency.

Drawbacks:

 Rigidity: Cannot adjust to economic shocks easily.

 Speculation: Potential for attacks on weak pegs.
 Crisis risk: High costs to defend peg during crises

Limitations of a pegged exchange rate:

1. Investor uncertainty: Stable exchange rates can attract foreign investment, but weak
economic/political conditions can raise doubts about the peg's sustainability.
2. Capital flight: Recessions can trigger capital flight as investors seek better opportunities
elsewhere, putting downward pressure on the local currency.
3. Central bank intervention: The central bank needs to intervene in the market to
maintain the peg, which can deplete reserves and limit its ability to address other
economic issues.
4. Potential for devaluation: If the peg breaks due to insufficient reserves or other factors,
the local currency can experience a sharp devaluation.
5. Loss of monetary policy independence: The central bank's ability to adjust interest rates
to manage inflation or economic growth is limited by the need to defend the peg.
Overall, pegged exchange rates offer stability but can be vulnerable to external shocks
and limit the central bank's ability to respond to economic challenges.
  Single European Currency:

 Definition: The euro (€), a common currency adopted by 20 European Union (EU)
countries, forming the eurozone.
 Established: January 1999, with full implementation in 2002.
 Member countries: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany,
Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal,
Slovakia, Slovenia, Spain.

 Eurozone:

 Definition: The region within the EU that uses the euro as its official currency.
 Economic power: Represents over 20% of the world's gross domestic product.

Direct Intervention:
 Central banks control money supply and currency value.
 Eurozone has a single central bank, the European Central Bank (ECB).
 ECB manages the euro's value against other currencies.

 Reasons for Intervention:

 Smooth out currency fluctuations.

 Set unofficial exchange rate boundaries.
 Respond to temporary economic disruptions.

Smoothing Exchange Rates:

 Central banks can intervene to reduce volatility in their currency's value, potentially
stabilizing business cycles and reducing financial market anxiety.
 This aims to encourage international trade by minimizing exchange rate
uncertainty.

Implicit Exchange Rate Boundaries:

 Central banks may maintain unofficial boundaries for their currency, signaling
potential intervention to prevent extreme fluctuations.
Indirect Intervention:

 Influencing economic factors like interest rates can indirectly affect the currency's
value.
 Raising interest rates can attract foreign capital and appreciate the local currency,
but effectiveness varies.

Responding to Temporary Disturbances:

 Central banks may intervene to counter temporary events that could cause undue
pressure on their currency.

Examples:

 The Fed intervenes to manage the US dollar's movement.

 Japan might intervene to stabilize the yen against oil price fluctuations.

Probable Question for exam:

1. Define Foreign Exchange market, Participants and its functions.

2. Define exchange rate mention some name of foreign currencies.

3. Briefly discuss the history of foreign exchange.

4.Discuss derivative contacts in foreign exchange market.

5. Define risks in international Bond.

6. Discuss the exchange rate system

7. Discuss Spot market, Bid/Ask Spread, Direct and Indirect Quotation

8. Discuss factors influencing spread..

9 Discuss direct an indirect Intervention.

10. Short notes:

Foreign exchange transaction, International bond market, International, Money market,
International Equity market, LIBOR,, Bretton woods Agreement, Smithsonian Agreement,
Dollarization, Single Euro Currency Foreign Exchange Market of Bangladesh.

1. Compare and contrast the fixed, freely floating, and managed float exchange rate
systems. What are some advantages and disadvantages of a freely floating exchange rate
system versus a fixed exchange rate system?

2. How can a central bank use direct intervention to change the value of a currency?
Explain why a central bank may desire to smooth exchange rate movements of its
currency

3. How can a central bank use indirect intervention to change the value of a currency?
 4 Determination of Foreign Exchange Rate

------------------------------------------------------------------------------------------------------------------------------------------------------------

 Introduction :
Financial managers of MNCs that conduct international business must continuously
monitor exchange rates because their cash flows are highly dependent on them. They
need to understand what factors influence exchange rates so that they can anticipate
how exchange rates may change in response to specific conditions.

 Measuring Exchange Rate Movements

Exchange rate movements affect an MNC's value because they can affect the amount of
cash inflows received from exporting products or services or from a subsidiary and the
amount of cash outflows needed to pay for imports of products or services. An exchange
rate measures the value of one currency in units of another currency. A decline in a
currency's value is known as depreciation. When the British pound depreciates against
the U.S. dollar, this means that the U.S. dollar is strengthening relative to the pound. An
increase in currency value is known as appreciation.
When a foreign currency's spot rate at two different times are compared, the spot rate at
the more recent date is denoted S and the spot rate at the earlier date is denoted as St-I.
The percentage change in the value of the foreign currency over a specified period is then
computed as follows: Percent change in foreign currency value = S-St-1/St-1.
A positive percentage change indicates that the foreign currency has appreciated over
the period, and a negative percentage change indicates that it has depreciated over the
period
On some days, most foreign currencies appreciate against the dollar (although by
different degrees); on other days, most currencies depreciate against the dollar (though
again by different degrees). There are also days when some currencies appreciate while
others depreciate against the dollar; the financial media describe this scenario by stating
that "the dollar was mixed in trading."
  Exchange Rate Equilibrium:
 Exchange rate is the price of one currency in terms of another.
 Imagine it like a market where currencies are traded.
 Equilibrium occurs when the demand for a currency equals its supply.
 This is the exchange rate where there's no pressure to change.

Key Points:

 Demand & Supply:

o Demand for a currency increases when it becomes cheaper relative to
others.
o Supply increases when a currency becomes more expensive.
 Price & Equilibrium:
o The exchange rate acts as the "price" of the currency.
o At equilibrium, this price balances demand and supply.
 Not Static:
o Conditions like interest rates, economic performance, and expectations can
change.
o These changes can shift demand and supply, affecting the equilibrium
exchange rate.

 Demand for a Currency:

Concept: Demand for a currency refers to the amount of that currency people or
businesses want to buy at a specific price (exchange rate).

Example: We're looking at the demand for British pounds (GBP) by Americans (USD).
Factors affecting demand:

 Trade: When US firms buy British goods, they need GBP. Higher demand for
British goods creates higher demand for GBP.
 Investment: US investors buying British stocks or bonds also need GBP. Higher
returns in the UK compared to the US can increase demand for GBP.

Impact of price (exchange rate):

 Downward sloping demand:

As the price of GBP (in USD) goes down, US demand for GBP goes up. Cheaper
pounds mean cheaper British goods and potentially better investment returns.

Upward sloping demand:

As the price of GBP (in USD) goes up, US demand for GBP goes down. Expensive
pounds make British goods and investments less attractive.

Equilibrium: The exchange rate settles at a point where the demand for GBP from the US
matches the supply of GBP available.

Supply of a Currency for Sale

Concept:

 The supply of a currency refers to the amount of that currency people are willing
to sell in exchange for another currency.
  In this case, we're looking at the British supply of pounds for sale in exchange
for US dollars.
 This can be seen as the flip side of the US demand for pounds.

Creates a positive relationship:

 Higher exchange rate (stronger GBP) leads to more pounds supplied
 Lower exchange rate (weaker GBP) leads to fewer pounds supplied

Factors affecting supply:

 Exchange rate:

As the value of the pound increases, people are more willing to sell pounds to get
dollars (supply increases). This is because they can buy more US goods with the
same amount of pounds.

 Demand for US goods:

If the demand for US goods and services in Britain is high, people are more likely
to sell pounds to get dollars to buy them (supply increases).

 Investment opportunities:

If there are attractive investment opportunities in the US, people may sell pounds to
get dollars to invest there (supply increases).

Key takeaway:

 The supply of a currency is not fixed, it depends on the exchange rate and other
factors.
 Understanding the supply and demand for currencies is crucial for
understanding currency exchange rates and international trade.

The supply schedule in Exhibit 4.3 shows a positive relationship between the pound's
value and the quantity of pounds for sale.

This is a general trend, but there may be exceptions due to other factors.
Equilibrium Exchange Rate:
Equilibrium Exchange Rate:

 It's the exchange rate where the demand for a currency equals the supply of that
currency.
 Imagine a market where people exchange currencies. At the equilibrium rate,
everyone who wants to buy pounds finds a seller, and vice versa. There's no
shortage or surplus of pounds.
Example:

 The text describes a scenario with two exchange rates: $1.50 and $1.60.
 At $1.50, more people want to buy pounds than there are pounds available. This
creates a shortage.
 At $1.60, more pounds are available than people want to buy, leading to a surplus.
 The equilibrium rate is found to be $1.55, where demand and supply match.

Why is it Important?

 The equilibrium exchange rate reflects the underlying economic conditions

between two countries.
 It helps businesses make informed decisions about international trade and
investments.
 Deviations from the equilibrium rate can signal potential imbalances or
inefficiencies in the market.

Change in the Equilibrium Exchange Rate:

Changes in the demand & supply schedules of a currency force a change in the
equilibrium exchange rate in the foreign exchange market. Before considering the factors
that could cause changes in the demand & supply schedules of a currency, it is important
to understand the logic of how such changes affect the equilibrium exchange rate. There
are 4 possible changes in market conditions that can affect this rate.
1. Increase in demand schedule
2. Decrease in demand schedule
3. Increase in supply schedule
4. Decrease in supply schedule

Demand & Supply Drive Changes:

 Increases in demand for a currency raise its exchange rate, while decreases lower
it.
 Similarly, increases in supply lower the rate, while decreases raise it

Banks Adjust Prices:

 Banks act as intermediaries, adjusting the exchange rate to balance demand and
supply.
 They raise the rate when demand exceeds supply (shortage) and lower it when
supply exceeds demand (surplus).
Visualizing the Changes:

 Imagine a single bank handling all demand and supply for a specific currency.
 Shifts in demand or supply curves graphically represent changes in market
conditions.
 The bank adjusts the exchange rate (price) until demand and supply are equal
(equilibrium).

Specific Examples:

 Increase in US demand for British pounds: raises pound exchange rate.

 Decrease in British demand for US dollars: lowers pound exchange rate.
 Increase in British supply of pounds for dollars: lowers pound exchange rate.
 Decrease in British supply of pounds for dollars: raises pound exchange rate.

Understanding the "Why":

 Price adjustments incentivize people to buy or sell less/more currency, bringing the
market back to equilibrium.

 Factors That Influence Exchange Rates :

Relative Inflation Rates:
Changes in relative inflation rates can affect international trade activity, which influences
the demand for and supply of currencies and therefore affects exchange rates.

Example:
Consider how the demand and supply schedules displayed in Exhibit 4.4 would be
affected if US inflation suddenly increased substantially while British Inflation remained
the same. (Assume that both British and US firms sell goods that can serve as substitutes
for each other.) The sudden Jump in U.S. Inflation should cause some U.S. consumers to
buy more British products Instead of U.S. products. At any given exchange rate, there
would be an increase in the US demand for British goods, which represents an increase
in the U.S. demand for British pounds in Exhibit 4.5. In addition, the jump in U.S. Inflation
should reduce the British desire for U.S. goods and thereby reduce the supply of pounds
for sale at any given exchange rate. These market reactions are illustrated in Exhibit 4.5.
At the previous equilibrium exchange rate of $1.55, there will now be a short age of
pounds in the foreign exchange market. The increased U S. demand for pounds and the
reduced supply of pounds for sale together place upward pressure on the value of the
pound. According to Exhibit 4.5, the new equilibrium value is $1.57. If British inflation
increased (rather than U.S. inflation), the opposite dynamic would prevail.

1. Higher inflation in a country:

 Decreases demand for its goods: As goods become more expensive due to
inflation, people might prefer substitutes from other countries, leading to a
decrease in demand for the high-inflation country's currency.
  Reduces supply of its currency:

People are less likely to invest in or hold onto a currency that's losing purchasing
power, leading to a decrease in the supply of the high-inflation currency.

 Net effect:

The decrease in demand and supply puts downward pressure on the high-
inflation country's currency, causing its value to depreciate (weaken) compared to
other currencies.

2. Lower inflation in a country:

 Increases demand for its goods:

As goods are relatively cheaper compared to other countries, people might prefer
buying from the low-inflation country, leading to an increase in demand for its
currency.

 Increases supply of its currency:

Investors are more likely to invest in or hold onto a currency with stable purchasing
power, leading to an increase in the supply of the low-inflation currency.

 Net effect:

The increase in demand and supply puts upward pressure on the low-inflation
country's currency, causing its value to appreciate (strengthen) compared to other
currencies.

3. Assumptions:

 The example assumes that both countries sell substitute goods.

 Other factors like interest rates, economic growth, and political stability also affect
exchange rates.

4. Analysis:

 The example simplifies the complex interaction of multiple factors influencing

exchange rates.
 It provides a basic framework for understanding how changes in relative inflation
rates can impact currency values.
Example:
Assume there is a sudden and substantial increase in British inflation while U.S. inflation
remains low.
(1) How is the demand schedule for pounds affected?
(2) How is the supply schedule of pounds for sale affected?
(3) Will the new equilibrium value of the pound increase, decrease, or remain
unchanged?

The answers are as follows:

(1) The demand schedule for pounds should shift inward.
(2) The supply schedule of pounds for sale should shift outward.
(3) The new equilibrium value of the pound will decrease. Of course, the actual amount
by which the pound's value will decrease depends on the magnitude of the shifts. Not
enough information is given here to determine their exact magnitude.

 Relative Interest Rates

Changes in relative interest rates affect investment in foreign securities, which
influences the demand for and supply of currencies and thus affects the
equilibrium exchange rate.

Example : Assume that U.S. and British interest rates are initially equal but then U.S.
interest rates rise while British rates remain constant. U.S. investors will likely reduce their
demand for pounds, because U.S. rates are now more attractive than British rates.
Because U.S. rates now look more attractive to British investors with excess cash, the
supply of pounds for sale by British investors should increase as they establish more bank
deposits in the United States. In response to this inward shift in the demand for pounds
and outward shift in the supply of pounds for sale, the equilibrium exchange rate should
decrease. These movements are represented graphically in Exhibit 4.6. If U.S. interest rates
decreased related to British interest rates, then the opposite shifts would be expected.

Example:
Assume that U.S. and British interest rates are initially equal but then British interest rates
rise while U.S. rates remain constant. British interest rates may become more attractive to
U.S. investors with excess cash, which would cause the demand for British pounds to
increase. At the same time, U.S. interest rates should look less attractive to British investors,
so the British supply of pounds for sale would decrease. Given this outward shift in the
demand for pounds and inward shift in the supply of pounds for sale, the pound's
equilibrium exchange rate should increase

Nominal vs. Real Interest Rate:

Nominal interest rate:
This is the stated interest rate on a loan or investment, without considering inflation. It
reflects the total return you get, but it doesn't tell you the true purchasing power of that
return.

Real interest rate:

This is the nominal interest rate adjusted for inflation. It reflects the actual increase in your
purchasing power after accounting for inflation. So, a real interest rate of 2% means your
investment is truly growing by 2% after inflation.
Although a relatively high interest rate may attract foreign inflows (to invest in securities
offering high yields), that high rate may reflect expectations of relatively high inflation.
Because high inflation can place downward pressure on the local currency, some foreign
investors may be discouraged from investing in securities denominated in that currency.
In such cases it is useful to consider the real interest rate, which adjusts the nominal
interest rate for inflation:
Real interest rate = Nominal interest rate - Inflation rate
This relationship is sometimes called the Fisher effect. The real interest rate is appropriate
for international comparisons of exchange rate movements because it incorporates both
the nominal interest rate and inflation, each of which influences exchange rates. Other
things held constant, a high US. real rate of interest (relative to other countries) tends to
boost the dollar's value.

Example:
Country A offers a nominal interest rate of 5% and has an inflation rate of 2%.
Country B offers a nominal interest rate of 3% and has an inflation rate of 1%.
Although Country A has a higher nominal interest rate, Country B actually has a higher
real interest rate of 2% compared to Country A's 3%. This could make Country B more
attractive to foreign investors, potentially leading to an appreciation of its currency.

Relative Income Levels :

A third factor affecting exchange rates is relative income levels. Because income can affect
the amount of imports demanded, it can also affect exchange rates.

Example: Assume that the U.S. income level rises substantially while the British income
level remains unchanged. Consider the impact of this scenario on (1) the demand
schedule for pounds, (2) the supply schedule of pounds for sale, and (3) the equilibrium
exchange rate.
First, the demand schedule for pounds will shift outward, reflecting the increase in U.S.
income and attendant increased demand for British goods.
Second, the supply schedule of pounds for sale is not expected to change. Hence the
equilibrium exchange rate of the pound should rise as shown in exhibit 4.7
This example presumes that other factors (including interest rates) are held constant. In
reality, of course, other factors do not remain constant. An increasing U.S. income level
likely reflects favorable economic conditions. Under such conditions, some British firms
would probably increase their investment in U.S. operations, exchanging more British
pounds for dollars so that they could expand their U.S. operations. In addition, British
investors may well increase their investment in U.S. stocks in order to capitalize on the
country's economic growth, a tendency that is also reflected in the increased sale
(exchange) of pounds for U.S. dollars in the foreign exchange market. Thus the supply
schedule of British pounds could increase (shift outward), which might more than offset
any impact on the demand schedule for pounds. Furthermore, an increase in U.S. income
levels (and in U.S. economic growth) could also have an indirect effect on the pound's
exchange rate by influencing interest rates. Under conditions of economic growth, the
business demand for loans tends to increase and thus cause a rise in interest rates. Higher
interest rates in the United States could attract more U.K.-based investors; this is another
reason why the supply schedule of British pounds may increase enough to offset any
effect of increased U.S. income levels on the demand schedule.

Government Controls:
A fourth factor affecting exchange rates is government controls. The governments of
foreign countries can influence the equilibrium exchange rate in the following ways:
(1) Imposing foreign exchange barriers;
(2) Imposing foreign trade barriers,
(3) Intervening (buying and selling currencies) in the foreign exchange markets, and
(4) Affecting macro variables such as inflation , interest rates, and income levels.

Example: Recall the example in which U.S. interest rates rose relative to British interest
rates. The expected reaction was an increase in the British supply of pounds for sale to
obtain more U.S. dollars (in order to capitalize on high U.S. money market yields).
However, if the British government placed a heavy tax on interest income earned from
foreign investments, such taxation would likely discourage the exchange of pounds for
dollars

Expectations:
A fifth factor affecting exchange rates is market expectations of future exchange rates.
Like other financial markets, foreign exchange markets react to any news that may have
a future effect. News of a potential surge in U.S. inflation may cause currency traders to
sell dollars. because they anticipate a future decline in the dollar's value. This response
places immediate downward pressure on the dollar.

Impact of Favorable Expectations

Many institutional investors (such as commercial banks and insurance companies) take
currency positions based on anticipated interest rate movements in various countries.
EXAMPLE Investors may temporarily invest funds in Canada if they expect Canadian
interest rates to increase, because this may cause further capital flows into Canada, which
could place upward pressure on the Canadian dollar's value. By investing in securities
denominated in Canadian dollars based on expectations, investors can fully benefit from
the rise in the Canadian dollar's value because they will have purchased Canadian dollars
before the change occurred. Although these investors face the obvious risk that their
expectations may be wrong, the point is that expectations can influence exchange rates
because they commonly motivate institutional investors to take foreign currency positions

Impact of Unfavorable Expectations :

Just as speculators can place upward pressure on a currency's value when they expect it
to appreciate, they can place downward pressure on a currency when they expect it to
depreciate.
EXAMPLE During the 2010-2012 period, Greece experienced a major debt crisis. because
of concerns that it could not repay its existing debt. Some institutional investors expected
that the Greece crisis might spread throughout the eurozone, which could cause a flow
of funds out of the eurozone. There were also concerns that Greece would abandon the
euro as its currency, which caused additional concerns to investors. who had investments
in euro-denominated securities.
Consequently, many institutional investors liquidated their investments in the eurozone,
exchanging their euros for other currencies in the foreign exchange market. Investors
who owned euro-denominated securities attempted to liquidate their positions before
the euro's value declined. These conditions played a large part in the euro's substantial
depreciation during this period.

Impact of a Currency Crisis :

A currency depreciates to such an extent that a currency crisis ensues. Many emerging
markets have experienced a currency crisis. Some emerging markets seem to have a
currency crisis every few years. Recent examples of countries experiencing a currency
crisis include Argentina, India, and Turkey in February 2014. Although the specific
conditions of each currency crisis vary among countries, an important factor in most crises
is substantial uncertainty about the country's future economic or political conditions.
When a country experiences political problems, its appeal to foreign and local investors
disappears. Foreign investors liquidate their investments and move their money out of the
country. Local investors may follow the lead of the foreign investors by liquidating their
investments and selling their local currency in exchange for the currencies of other
countries so that they can move their money to a safer (more politically stable)
environment

Impact of Signals on Currency Speculation :

Day-to-day speculation on future exchange rate movements is typically driven by signals
of future interest rate movements, but it can also be driven by other factors. Signals of the
future economic conditions that affect exchange rates can change quickly; hence
speculative positions in currencies may adjust quickly, which increases exchange rate
volatility. It is not unusual for a currency to strengthen substantially on a given day, only
to weaken substantially on the next day. This can occur when speculators overreact to
news on one day (causing a currency to be overvalued), which results in a correction on
the next day. Overreactions occur because speculators often take positions based on
signals of future actions (not on the confirmation of past actions), and these signals may
be misleading.

Interaction of Factors

Exchange rates are influenced by two main types of money flows:

1. Trade-related:

This includes money exchanged for buying and selling goods and services
between countries.

2. Finance-related:

This includes investments, loans, and other financial transactions.

Different factors affect each type of flow:

 Trade-related:
Mainly influenced by relative inflation rates (higher inflation weakens a currency).

 Finance-related:
 Mainly influenced by interest rates (higher rates attract investment, strengthening a
currency).

The influence of each factor depends on the size of transactions:

 More trade: Inflation rates matter more.

 More financial transactions: Interest rates matter more.

Exhibit 4.8 separates payment flows between countries into trade-related and finance-
related flows; it also summarizes the factors that affect these flows. Over a particular
Period, some factors may place upward pressure on the value of a foreign currency while
other factors place downward pressure on that value.

 Summary
Exchange rate movements are commonly measured by the percentage change in their
values over a specified period, such as a month or a year. Multinational corporations
closely monitor exchange rate movements over the period in which they have cash flows
denominated in the foreign currencies of concern. The equilibrium exchange rate
between two currencies at any time is based on the demand and supply conditions.
Changes in the demand for a currency or in the supply of a currency for sale will affect
the equilibrium exchange rate.
The key economic factors that can influence exchange rate movements through their
effects on demand and supply conditions are relative inflation rates, interest rates, income
levels, and government controls. When these factors lead to a change in international
trade or financial flows, they affect the demand for a currency or the supply of currency
for sale and thus the equilibrium exchange rate.

Financial institutions may attempt to profit from their expectation that a currency will
appreciate by investing in securities denominated in that currency. They might also
attempt to profit from their expectation. that a currency will depreciate by borrowing that
currency, exchanging it for their home currency, and paying off the loan once the
borrowed currency has depreciated.

1. Percentage Depreciation
Assume the spot rate of the British pound is $1.73. The expected spot rate 1 year from
now is assumed to be $1.66. What percentage depreciation does this reflect?

2. Inflation Effects on Exchange Rates

Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other
things being equal, how should this affect the (a) U.S. demand for Canadian dollars,
(b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian
dollar?

3. Interest Rate Effects on Exchange Rates

Assume U.S. interest rates fall relative to British interest rates. Other things being equal,
how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for
sale, and (c) equilibrium value of the pound?

4. Income Effects on Exchange Rates

Assume that the U.S. income level rises at a much higher rate than does the Canadian
income level. Other things being equal, how should this affect the (a) U.S. demand for
Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of
the Canadian dollar?

5. Trade Restriction Effects on Exchange Rates

Assume that the Japanese government relaxes its controls on imports by Japanese
companies. Other things being equal, how should this affect the (a) U.S. demand for
Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?
Arbitrage
In finance, arbitrage is the process of buying something cheap in one market and selling
it for more in another, capitalizing on price differences. It's like exploiting a temporary
glitch in the system to make a quick profit.
The type of arbitrage takes three common forms:
1. locational arbitrage,
2. triangular arbitrage, and
3. covered interest arbitrage

Locational arbitrage
Buying a currency cheaper in one location and selling it for more in another. Example:
buying pounds for $1.60 and selling them for $1.61.

Example: Akron Bank and Zyn Bank serve the foreign exchange market by buying
and selling currencies. Assume that each bank is willing to buy a currency for exactly
the same rate at which it is willing to sell that currency (there is no bid/ask spread).
Assume the exchange rate quoted at Akron Bank for a British pound is $1.60 while
the exchange rate quoted at Zyn Bank is $1.61. You could conduct locational arbitrage
by purchasing pounds at Akron Bank for $1.60 per pound and then selling them at
Zyn Bank for $1.61 per pound. If there is no bid/ask spread and if there are no other
costs of conducting this arbitrage strategy, then your gain would be $.01 per pound.
The gain is risk free in that you knew, when you purchased the pounds, how much
 you could sell them for. Also, you did not have to tie your funds up for any length of
time.
Locational arbitrage is normally conducted by banks or other foreign exchange
dealers whose computers can continuously monitor the quotes provided by other
banks. If other banks observed a discrepancy between the prices quoted by Akron
Bank and Zyn Bank, then these other banks would quickly engage in locational
arbitrage to earn an immediate risk-free profit. In reality, banks have a bid/ask spread
on currencies, which is their way of generating a profit from providing foreign
exchange services. The following example accounts for that spread.

Example: In Exhibit 7.1 the information given previously on British pounds at both
banks is revised to include a bid/ask spread. Based on these quotes, you can no longer
profit from locational arbitrage. If you buy pounds at $1.61 (Akron Bank's ask price)
and then sell them at $1.61 (Zyn Bank's bid price), you just break even. As this example
demonstrates, locational arbitrage will not always be possible. To achieve profits from
this strategy, the bid price of one bank must be higher than the ask price of another
bank.

Gains from Locational Arbitrage

Your gain from locational arbitrage is based on two factors:
1) The amount of money that you use to capitalize on the exchange rate
discrepancy
2) and the size of that discrepancy

Triangular arbitrage:
Exploiting discrepancies between multiple cross-currency exchange rates. Example:
converting dollars to pounds, then to ringgits, then back to dollars for a profit.
Cross exchange rates express the relation between two currencies that each differ from
one's base currency.
In the United States, the term cross exchange rate refers to the relationship between two
non-dollar currencies.

Example: If the British pound (£) is worth $1.60 and if the Canadian dollar (CS) is
worth $.80, then the value of the British pound with respect to the Canadian dollar is
calculated as follows:

Value of £ in units of C$= $1.60/$.8 = 2.0

The value of the Canadian dollar in units of pounds can also be determined from the
cross exchange rate formula:
Value of CS in units of £= $.80/ $1.60 = .50

Gains from Triangular Arbitrage

If a quoted cross exchange rate differs the appropriate cross exchange rate (as
determined by the preceding formula), you ca attempt to capitalize on the
discrepancy. Specifically, you can use triangular which currency transactions are
conducted in the spot market to capitalize on a discrepancy in the cross exchange rate
between two currencies.
EXAMPLE Assume that a bank has quoted the British pound (£) at $1.60, the ringgit
(MYR) at $.20, and the cross exchange rate at £1= MYR8.1. The Malaysian task is to
use the pound value in U.S. dollars and Malaysian ringgit value in U.S. dollars to
develop the cross exchange rate that should exist between the pound and the
Malaysian ringgit. The cross rate formula in the previous example reveals that the
pound should be worth MYR8.0.
When quoting a cross exchange rate of E1= MYR8.1, the bank is exchanging too many
ringgit for a pound and is asking for too many ringgit in exchange for a pound. Based
on this information, you can engage in triangular arbitrage by purchasing pounds
with dollars, converting the pounds to ringgit, and then exchanging the ringgit for
dollars. If you have $10,000, then how many dollars will you end up with if you
implement this triangular arbitrage strategy? The following steps, which are illustrated
in Exhibit 7.3, will help you answer this question.

1. Determine the number of pounds received for your dollars: $10,000=

£6,250, based on the bank's quote of $1.60 per pound.
2. Determine how many ringgit you will receive in exchange for pounds:
£6,250= MYR50,625, based on the bank's quote of 8.1 ringgit per pound.
3. Determine how many U.S. dollars you will receive in exchange fir the
ringgit: MYR50, 625= $10125 based on the bank’s quote of $.20 per ringgit
(5 ringgit to the dollar). The triangular arbitrage strategy generates
$10,125, which is $125 more than you started with
Covered interest arbitrage Process
Covered interest arbitrage is the process of capitalizing on the difference in interest rates
between two countries while covering your exchange rate risk with a forward contract.
The term covered interest arbitrage is composed of two parts: "interest arbitrage" refers to
the process of capitalizing on the difference between interest rates between two
countries; "covered" refers to hedging your position against exchange rate risk. The
forward rate of a currency for a specified future date is determined by the interaction of
demand for the contract (forward purchases) versus the supply (forward sales). Forward
rates are available for many currencies at financial websites. Financial institutions that
offer foreign exchange services set the forward rates, but these rates are driven by market
forces (demand and supply conditions). In some cases, the forward rate may be priced at
a level that allows investors to engage in a type of arbitrage that affects the volume of
forward purchases or forward sales of a particular currency, and therefore affects the
equilibrium forward rate.
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:

1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British
bank
2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will
have £520,000 (including interest).
3. In 90 days when the deposit matures, you can fulfill you your forward contract
obligation by converting your £520,000 into $832,000 (based on the forward contract
rate of $1.60 per pound)
  Comparing Different Types of Arbitrage

The threat of locational arbitrage ensures that quoted exchange rates are similar
across banks at different locations; the threat of triangular arbitrage ensures that cross
exchange rates are properly set; and the threat of covered interest arbitrage ensures
that forward exchange rates are properly set. Any discrepancy will trigger arbitrage,
which should eliminate the discrepancy. Thus arbitrage tends to ensure a more orderly
foreign exchange market.

 Interest Rate Parity (IRP)

When market forces cause interest rates and exchange rates to adjust such that
covered interest arbitrage is no longer feasible, the result is an equilibrium state known
as interest rate parity (IRP).
In equilibrium, the forward rate differs from the spot rate by a sufficient amount to
offset the interest rate differential between two currencies

 Determining the Forward Premium

Using the information just presented, the forward premium (or discount) can be
measured based on the interest rate difference under conditions of IRP.
 Example : Assume that the Mexican peso exhibits a six-month interest rate of 6
percent and that the U.S. dollar exhibits a six-month interest rate of 5 percent. From a
U.S. investor's perspective, the U.S. dollar is the home. currency. According to IRP, the
forward rate premium of the peso with respect to the U.S. dollar should be:
P={( 1+. 05)/( 1+.06)}-1
= -.0094 or -.94% ( not annualized)
Thus the six-month forward contract on the peso should exhibit a discount of
about.94 percent. This means that U.S. investors would receive .94 percent less when
selling pesos six months from now (based on a forward sale) than the price they pay
for pesos today at the spot rate.
Such a discount would offset the peso's interest rate advantage.
If the peso's spot rate is $.10, then a forward discount of .94 percent results in the
following calculation of the six-month forward rate:
F= $ ( 1+P)
= $.10 ( 1-.0094)
=$.09906

 Considerations When Assessing Interest Rate Parity

Transaction Costs:

 IRP assumes no costs, but real-world transactions have fees.

 Consider arbitrage worthwhile only if the interest differential & forward premium
exceed a certain threshold (dark shaded band around the IRP line in Exhibit 7.10).
  This band represents the "cost buffer" within which arbitrage isn't profitable.

Political Risk:

 Even with locked-in conversion rates, political instability might prevent actual
currency exchange.
 Investors face the risk of foreign governments restricting currency exchanges in
times of crisis.
 Default risk on foreign investments adds another layer of uncertainty.
 Some investors might prefer lower domestic returns over slightly higher foreign
ones due to these risks.

Differential Tax Laws:

 Tax implications vary by country, impacting overall returns from arbitrage.

 Arbitrage might be attractive before-tax but not after considering tax differences.

Purchasing Power Parity (PPP)

MNCs, Financial managers of MNCs must understand how inflation and interest rates
can affect exchange rates so that they can anticipate how their MNCs may be affected.
One of the most popular and controversial theories in international finance is the
purchasing power parity (PPP) theory, which attempts to quantify the relationship
between inflation and the exchange rate.

Interpretations of Purchasing Power Parity

There are two popular forms of PPP theory, each with its own implications.

Absolute PPP:

 Prices of the same basket of goods in different countries should be equal when
adjusted for currency exchange.
 Consumers shift demand to countries with lower prices, driving prices towards
equality.
 Not fully realistic due to transportation costs, tariffs, and quotas.

Relative PPP:

 Prices of the same basket of goods might differ due to trade barriers,
but changes in prices should be comparable.
  Example: If US inflation is 9% and UK inflation is 5%, the pound should appreciate
by 4% to maintain relative price levels.
 More realistic than absolute PPP, but still has limitations.

 Rationale behind Relative PPP Theory

The relative PPP theory is based on the notion that exchange rate adjustment is
necessary for the relative purchasing power to be the same whether buying products
locally or from another country. If that purchasing power is not equal, then consumers
will shift purchases to wherever products are cheaper until purchasing power
equalizes.

 International Fisher Effect (IFE)

The International Fisher Effect (IFE) is a theory that establishes a connection between the
nominal interest rates of two countries and the anticipated movement of exchange rates.
It provides a framework for estimating expected inflation rates based on nominal interest
rates. The key points are:
Nominal Interest Rates: The IFE focuses on the nominal interest rates of two countries.
Expected Inflation Rates: It suggests that nominal interest rates can be used to derive
expected inflation rates for each country.
Differential in Inflation Rates: The theory emphasizes the difference in inflation rates
between two countries, indicating how this disparity signals an expected change in the
exchange rate.
Exchange Rate Movement: The IFE posits that the relationship between nominal interest
rates and expected inflation rates can help predict the direction of exchange rate
movements.

It suggests (1) how each country's nominal interest rate can be used to derive its expected
inflation rates, and (2) how the difference in inflation rates between two countries signals
an expected change in the exchange rate.
In essence, the IFE provides insights into how interest rate differentials may influence
exchange rate expectations, contributing to the understanding of international financial
markets.
 5&6
Foreign Exchange Risk Exposure and Management
-----------------------------------------------------------------------------------------------------------------------------------------------------------

Basic concept:
Financial managers of multinational companies (MNCs) need to understand how to
measure the impact of changes in exchange rates on their business. This is important
because these changes can affect the company's cash flow, performance, and value.

 If an MNC is exposed to exchange rate risk, its cash flows (and therefore its
performance and value) could be negatively affected by changes in
exchange rates. By reducing their exposure to exchange rate risk, MNCs
can potentially stabilize their earnings and cash flows. This can help to
reduce the risk that the MNC's stock price will go down and make it easier
for the MNC to repay its debts over time. This can also allow the MNC to
borrow money at a lower cost.

 So, if a company makes money in one country but spends money in

another country, then changes in the exchange rate between those two
countries can affect how much money the company has. By
understanding how exchange rates might change, the company can
make better decisions about how to manage its money.

Transaction exposure:
The sensitivity of the firm’s contractual transactions in foreign currencies to
exchange rate movements is referred to as transaction exposure.Basically,
transaction exposure is the risk a company faces when it does business in a
foreign currency.
For example, US company Seahawk Co. that sells products to a company in Spain.
Seahawk Co. will receive 1 million euros in 90 days. They are concerned about the
exchange rate at the time they receive the euros, because it will determine how many
dollars they get.
 If the euro weakens (goes down in value) compared to the dollar, Seahawk Co.
will receive fewer dollars. Again, If the euro strengthens (goes up in value)
compared to the dollar, Seahawk Co. will receive more dollars.

 The company is exposed to the risk of the euro weakening because they won't
get as many dollars as they expected. They can hedge this risk by using financial
instruments to lock in an exchange rate today.

 Assessing transaction exposure for multinational companies (MNCs) is more

complex than it might seem beacuse an MNC is a company that operates in more
than one country. For example, imagine a company that makes cars in the United
States but sells them in Europe. This company would be an MNC.

 When an MNC does business in a foreign country, it often has to deal in that
country's currency. This can be risky because the value of currencies can change
over time. For example, the value of the euro could go up or down compared to
the value of the US dollar.

 Thus an MNC should-----

 Estimate the expected net cash flows for each currency over the next
quarter (The total amount of money it expects to receive and owe in each
foreign currency over a certain period of time)
 Assess its exposure to all these currencies as a portfolio over the next
quarter.. Estimate the total amount of money it expects to receive and owe
in each foreign currency over a certain period of time (usually a quarter).

 By doing this, the MNC can get a better idea of how much it is exposed to
changes in foreign currency exchange rates. This can help the company to make
better decisions about how to manage its foreign currency risk.

 Imagine you are a company that sells lemonade. You sell lemonade in dollars,
but you buy your lemons from a supplier in Mexico and have to pay them in
pesos. The price of lemons (in pesos) could go up or down, and the exchange
rate between pesos and dollars could also go up or down. This means that the
cost of making your lemonade could change even if the price of lemons in pesos
stays the same.
  Estimation “net” cashflow in each currency :
To measure transaction exposure over the next quarter, an MNC should identify
all transactions denominated in a foreign currency that will occur during the
quarter and categorize the transactions by whether they are cash inflows or cash
outflows. Because cash outflows that must be paid in a particular currency at the
end of the quarter partially offset the cash inflows that will be received in that
same currency at the end of the quarter, the MNC’s transaction exposure focuses
only on the “net” cash flows, measured as cash inflows minus cash outflows for a
particular currency.

 Transaction exposure of an MNC's Portfolio:

 After estimating net dollar cash flows per currency for an upcoming period (such
as the next quarter), an MNC can assess the degree of transaction exposure of its
portfolio of currencies.
 The transaction exposure of the currency portfolio represents the degree of
uncertainty surrounding the portfolio’s value, which is caused by the uncertain
exchange rate movements of the currencies in the portfolio. A currency portfolio
that is subject to more uncertainty is more exposed to a pronounced reduction in
value over the next quarter.

 How exchange rate changes impact MNC's:

 Transactions over time:

MNC’s often agree on overseas sales or purchases well in advance of the actual
payment date. This gap creates uncertainty.
 Uncertainty: If exchange rates change unfavorably during this gap, the
MNC could lose money when converting foreign currency back to their
home currency.
 Portfolio approach: An MNC needs to think of all the different currencies it
deals with as a portfolio. The risk depends on how much each currency
changes (volatility) and how much they move together (correlation).
Example: A US-based MNC expects to earn $100,000 worth of Currency X and
$100,000 worth of Currency Y in the next quarter.
 Before the quarter ends, both Currency X and Currency Y potentially
weaken against the US dollar.
 When they convert their earnings, they have less than the $200,000 they
expected. This reduces their profit even though sales were as planned.
 If the dollar value of this two-currency portfolio has been very stable (low
volatility) over the past several quarters, there is little risk that the portfolio value
will decline substantially when converting the two currencies to dollars at the
end of the next quarter.

 Conversely, if the dollar value of the two-currency portfolio has been very volatile
over the past several quarters, there is much risk that the portfolio value will
decline substantially when converting the two currencies to dollars at the end of
the next quarter. In this case, the transaction exposure of the MNC’s portfolio is
relatively high.

 Factor that affect the maximum one-day:

The maximum expected loss on a currency over the next quarter depends on three
factors.
First, it depends on the expected percentage change in the currency for the next
quarter. If the expected percentage change in the currency’s value was more
pronounced than the 1 percent depreciation assumed in the previous example,
the maximum expected loss would be more pronounced.

Second, a higher confidence level (such as 99 percent confidence instead of 95

percent confidence) will lead to a greater maximum expected loss (when all
other factors are held constant).

Third, the maximum expected loss over the next quarter depends on the
standard deviation of the currency’s quarterly exchange rate movements over a
previous period.

 Economic exposure:
The overall sensitivity of a firm’s cash flows to exchange rate movements is
referred to as economic exposure (also sometimes referred to as operating
exposure), which is a broader concept than transaction exposure. Indeed,
transaction exposure can be thought of as a subset of economic exposure. But
whereas transaction exposure focuses on the impact of exchange rate
movements on an MNC’s contractual international transactions , economic
exposure encompasses all of the ways that an MNC’s cash flows can be affected
by exchange rate movements.
  Economic exposure, which is the impact of currency fluctuations on a company's
cash flows. But transaction exposure focuses on the immediate impact of
exchange rates on a company's existing contracts.

 Economic exposure considers all the ways a company's cash flow can be affected
by exchange rates, even in the long run.

 For example,
 Intel sells computer chips in U.S. dollars to European customers.
 If the Euro (Europe's currency) gets weaker, Europeans need more Euros to buy
the same chips.
 This might make Europeans buy fewer chips from Intel, hurting Intel's sales.

Even a U.S. firm that has no international business can be subject to economic exposure.
If a foreign competitor’s invoice currency depreciates against the dollar, some customers
may shift their purchases to the foreign competitor.
Thus the demand for the U.S. firm’s products will decrease, and its net cash inflows will
decrease as well. Although MNCs use a short-term perspective when assessing their
transaction exposure, they tend to use a long-term perspective when assessing their
economic exposure.

 Transaction exposure vs economic exposure:

1) Definition :

Transaction exposure:
It is the short-term impact of exchange rates on a company's existing contracts, like
buying or selling goods in foreign currencies.

Economic exposure:
It is the broader, long-term impact of . exchange rates on a company's overall cash flow,
including factors beyond immediate contracts.
2) Example: The example of Intel, a US company, highlights this difference. Even
though they invoice exports in dollars to avoid transaction exposure, a weakening Euro
could still hurt their sales. European customers may switch to European manufacturers
due to the cheaper prices, impacting Intel's cash flow in the long run.Even companies
without international business can be affected. If a US company's competitor's currency
weakens, the competitor's products become cheaper, potentially leading US customers
to switch, impacting the US company's cash flow.
3) Timeframe:
Companies typically assess transaction exposure with a short-term perspective,
focusing on immediate contracts. On the contrary, Economic exposure is assessed
with a long-term perspective, considering the overall impact of exchange rates on
cash flow over time.
In conclusion, understanding economic exposure is crucial for companies, especially in
today's globalized economy, as even seemingly unrelated currency fluctuations can
impact their bottom line.

 Translation exposure: When a multinational company (MNC)

combines its subsidiaries' financial statements, it does so in the parent
company's currency. This requires translating each subsidiary's statements,
originally in their local currency, which creates a risk called translation
exposure.
 Merging subsidiaries' financial statements into a single report
exposes an MNC to translation exposure. This is because currency
fluctuations can skew the translated value of subsidiary earnings,
even if their actual performance remains constant.

Determination of translation exposure: Some MNCs have more translation

exposure than others. The extent of an MNC’s translation exposure depends mainly on
three factors:
1)The proportion of its business conducted by foreign subsidiaries.
2)The locations of its foreign subsidiaries and
3)The accounting methods that it uses.

1) The proportion of its business conducted by foreign subsidiaries:

The greater the percentage of an MNC’s business conducted by its foreign subsidiaries,
the larger the percentage of a given financial statement item that is susceptible to
translation exposure.
Foreign subsidiaries generate income and expenses in foreign currencies.
These foreign currency amounts need to be converted into the parent company's
currency for consolidation of financial statements.
Fluctuations in exchange rates can change the value of these converted amounts, even
if the underlying business performance remains the same.

Example: Locus Co. exports directly, meaning it sells products made in its home country
to foreign customers. Their foreign sales are already in a foreign currency, so no
conversion is needed for their financial statements. Therefore, they have no translation
exposure.But, Zeuss Co. has a Mexican subsidiary, meaning they have a separate
company operating in Mexico. This subsidiary generates income in Mexican pesos,
which needs to be converted to the parent company's currency (e.g., USD) for financial
statements, creating translation exposure.

2) The location of it's foreign subsidiaries :

The countries in which subsidiaries are located can also influence the
degree of translation exposure because the financial statement items of
each subsidiary are typically measured by the respective subsidiary’s home
currency.
Example: Zeuss has a branch in Mexico with a weaker currency (prone to
big changes). This means even if the branch does well, exchange rate
changes can make it look worse on the main company's books due to
translation (changing pesos to their main currency). This is high translation
exposure.
Canton has a branch in Canada with a stronger, stable currency. So, even
with exchange rate changes, the branch's performance on the main
company's books won't swing much. This is low translation exposure.

3) The accounting method that it uses: An MNC’s degree of translation exposure

is strongly affected by the accounting procedures used to translate when consolidating
financial statement data. Many important consolidated accounting rules for U.S.-based
MNCs are based on FASB 52, which includes the following provisions:

a) Functional Currency: FASB 52 emphasizes using the currency of

the economic environment where the foreign subsidiary operates (its
functional currency) for its financial statements.

b) Translation of Assets & Liabilities: Current exchange rates at the

reporting date are used to convert the assets and liabilities of the foreign
entity into the parent company's currency.

c) Translation of Revenue, Expenses, etc : Revenue, expenses, gains, and

losses are translated using the weighted average exchange rate for the
relevant period. This helps smooth out fluctuations compared to using the
current rate.
 d) Translation Adjustments: Income gains or losses arising solely from
exchange rate changes are NOT included in current net income but are
reported as a separate component of shareholder equity. This is to isolate
the impact of exchange rates from the actual business performance.

e) Realized Gains or Losses: Gains or losses from actual foreign

currency transactions (e.g., buying or selling foreign currency) are
recorded in current net income, with some exceptions.

 Transaction exposure: It arises from foreign currency

contracts where exchange rates impact the dollar value at
settlement. This can significantly increase costs (payables) or
reduce profits (receivables). To manage this risk, MNCs often
hedge these transactions, aiming to stabilize cash flows and
enhance their value.

 Policies for hedging transaction exposure:

Some MNCs hedge most of their exposure so that their value is
not strongly influenced by exchange rates. Multinational
corporations that hedge most of their exposure do not
necessarily expect that hedging will always be beneficial. In fact,
they might even use some hedges that will likely result in slightly
worse outcomes than no hedges at all, just to avoid the
possibility of a major adverse movement in exchange rates.
Hedging most of the transaction exposure allows MNCs to more
accurately forecast future cash flows (in their home currency) so
that they can make better decisions regarding the amount of
financing they will neeThere are two approaches to hedging
transaction exposure for MNCs:

1) Extensive Hedging:
 Aims to minimize the impact of exchange rates on the value of the MNC.
 May involve some unfavorable hedges to avoid potential major losses from
exchange rate fluctuations.
 This strategy improves forecasting of future cash flows (in home currency),
enabling better financing decisions.
2) Selective Hedging:
 Evaluates each transaction individually for hedging.
 Highly diversified MNCs might avoid hedging altogether, believing diversification
will mitigate exchange rate impact on overall cash flows.
In essence, the choice between extensive and selective hedging depends on the MNC's
risk tolerance and the level of diversification in their operations.

 Hedging exposures techniques:

1)Forward /future option hedge

2) Money market hedge
3)Currency option hedge

1)Forward/future option hedge:

Forward contracts and futures contracts can be used by MNCs to hedge payables
in a specific f: A forward contract is negotiated between the firm and a financial
institution such as a commercial bank, so it can be tailored to meet the firm’s
specific needs.
The contract will specify:

a) The currency that the firm will pay,

b)The currency that the firm will receive,
c) The amount of currency to be received by the firm,
d) The rate at which the MNC will exchange currencies (the “forward” rate), and
e) The future date at which the exchange of currencies will occur.oreign
currency. They achieve this by locking in a predetermined exchange rate
(forward rate) for the future purchase of a specific amount of the foreign
currency.

 A forward contract is negotiated between the firm and a financial institution

such as a commercial bank, so it can be tailored to meet the firm’s specific
needs.The contract will specify:
a) The currency that the firm will pay,
b) The currency that the firm will receive,
c)The amount of currency to be received by the firm,
d)The rate at which the MNC will exchange currencies (the “forward” rate),
and
e)The future date at which the exchange of currencies will occur.
 Example: Coleman Co. (US-based MNC) needs 100,000 euros in one year.The
one-year forward rate (and futures rate) is $1.20 per euro.
Cost Calculation:
Cost in dollars = Payables in euros x Forward rate
Cost = 100,000 euros x $1.20/euro
Cost = $120,000
By locking in the forward rate, Coleman Co. knows exactly how much they will need to
pay in US dollars in one year, regardless of potential exchange rate fluctuations. This
protects them from unexpected currency movements that could increase their costs.

2) Money market hedge on payables:

Money market hedges can be used by MNCs to manage payables without using their
own cash.This method involves two steps:
a) Borrowing: The MNC borrows funds in their home currency.
b) Investing: They use the borrowed funds to invest in short-term instruments of the
foreign currency they owe the payment in.
3) Call option hedge on payable: A currency call option provides the right to buy a
specified amount of a particular currency at a specified price (called the strike price or
exercise price) within a given period of time.

 Yet unlike a futures or forward contract, the currency call option does not
obligate its owner to buy the currency at that price. The MNC has the flexibility to
let the option expire and obtain the currency at the existing spot rate when
payables are due.
 However, a firm must assess whether the advantages of a currency option hedge
are worth the price (premium) paid for it.
Example : Coleman Co. buys call options giving them the right to buy 100,000 euros at
$1.20 per euro.
Premium: They pay a premium of $0.03 per euro for this right (a total of $3,000
for all the options).
If Euro Strengthens: If the spot exchange rate in one year is higher than $1.20,
Coleman can exercise the options and buy euros at the more favorable $1.20
rate. Their effective cost per euro is the strike price plus the premium ($1.23),
limiting their loss due to an unfavorable exchange rate.

If Euro Weakens: If the spot rate is below $1.20, Coleman lets the options expire.
They will lose the premium, but they can buy euros at the cheaper spot market
rate.
  Hedging exposures to receivables :
MNCs can hedge receivables in foreign currency to protect themselves from
currency depreciation. They can use the same techniques as for payables:
1) Hedge on receivables:
Future/ forward contracts lock in a selling rate for the foreign currency on a
specific future date. This guarantees a minimum dollar amount received
regardless of the actual exchange rate at that time.
Example: Viner Co. (US) expects to receive 200,000 Swiss francs (SF) in 6 months.They
can buy a forward contract to sell SF200,000 at a fixed rate of $.71/SF.This guarantees
at least $142,000 (200,000 SF * $.71) regardless of future exchange rates.

2) Money market hedge for receivables:

A money market hedge aims to lock in the value of foreign currency receivables by
borrowing in that same currency and using the receivables to repay the loan.
Example: Viner Co. expects to receive SF200,000 in 6 months.They can borrow
SF194,175 at a 6-month interest rate of 3%.This amount ensures they can repay the loan
entirely with the SF200,000 receivables.
3) Put option hedge on receivables: A put option grants the right, but not the
obligation, to sell a specific amount of foreign currency at a predetermined exercise
price by a specific expiration date.MNCs can buy put options on their receivables
currency.
This locks in a minimum amount of domestic currency received, regardless of future
exchange rate fluctuations.

Limitations of Hedging :
When hedging international transactions with uncertain amounts, companies face two
main limitations:
1. Overhedging:
Companies might hedge for a larger amount than the actual transaction fearing to be
under-hedged.
This leads to buying more foreign currency than needed, potentially at a higher cost if
the currency appreciates.
This scenario creates the opposite risk (unintended exposure) and can lead to
unexpected costs.
2. Incomplete Hedging:
Hedging only the minimum guaranteed amount avoids overhedging costs but leaves
the company partially exposed.

 Limitation of repeated short term hedging:

Hedging transactions frequently for the short term has limitations:

a) Limited Long-Term Effectiveness:

Short-term hedging might not offer long-term protection against exchange rate
fluctuations.
b) Uncertainty in Future Amounts:
Predicting future shipment sizes and, consequently, the amount of foreign currency
needed, becomes more difficult due to factors like economic conditions.
c) Potential for Unintended Obligations:
If future demand decreases, a company might be stuck purchasing more foreign
currency than needed through the pre-established forward contracts, leading to
potential losses.

 Alternative Methods to Reduce Exchange rate risk:

There are 3 methods:
1. Leading and lagging
2. Cross hedging
3. Currency diversification

1. Leasing and lagging:

Leading and lagging are strategies companies use to manage foreign exchange risk by
adjusting the timing of payments based on anticipated currency fluctuations:
Leading: If a company expects their currency to depreciate, they expedite payments to
the foreign company to lock in a favorable exchange rate before it weakens.
Lagging: If a company expects their currency to appreciate, they delay payments to the
foreign company, requiring fewer units of their currency to fulfill the obligation when
the exchange rate becomes more favorable.
2.Cross hedging :
Cross hedging is a common method of reducing transaction exposure when the
currency cannot be hedged.
Example: Greeley Co., a U.S. firm, has payables in zloty (Poland’s currency) 90
days from now. Because it is worried that the zloty may appreciate against the
U.S. dollar, the company may want to hedge this position. If forward contracts
and other hedging techniques are not available for the zloty, then Greeley may
consider cross-hedging.

 The first step is to identify a currency that can be hedged and that also is
highly correlated with the zloty. Greeley observes that the euro has
recently been moving in tandem with the zloty and decides to set up a 90-
day forward contract on the euro. If the movements in the zloty and euro
continue to be
highly correlated (i.e., if the two currencies continue to move in the same
similar direction and to a similar extent), then the exchange rate between
them should be fairly stable over time.

 The next step is for Greeley to purchase euros 90 days forward, which
enables the company to exchange euros for the zloty when zloty are
required for payment.

 Proxy hedge: proxy hedge relies on the correlation between the

currencies. The stronger the correlation, the more effective the cross-
hedging strategy becomes.

3) Currency diversification :

MNCs (multinational corporations) can use currency diversification as a

strategy to reduce their exposure to fluctuations in any single currency.
This approach aims to limit the overall impact of currency movements on
the company's value.

Examples:
The Coca-Cola Co., PepsiCo, and Altria use currency diversification as part of their overall
risk management strategy.

Key concept: Diversifying business across multiple countries results in revenue streams
in various currencies. Ideally, these currencies should have low correlations with each
other.
Lower correlations mean the currencies move somewhat independently, reducing the
overall variability of the company's dollar-denominated inflows.
 7 International Investment

Multinational corporations (MNCs) evaluate international projects by using multinational

capital budgeting, which compares the benefits and costs of these projects. More
specifically, MNCs determine whether an international project is feasible by comparing
the present value of that project’s expected future cash flows to the initial investment
that would be necessary for that project. This type of evaluation of international projects
is similar to the evaluation of domestic projects.

Subsidiary versus Parent Perspective

Normally, multinational capital budgeting should be based on the parent’s perspective.
Some projects might be feasible for a subsidiary but not feasible for the parent, as net
after-tax cash inflows to the subsidiary can differ substantially from those to the parent.
Such differences in cash flows between the subsidiary and the parent can be due to
several factors,

Tax Differentials
Restrictions on Remitted Earnings
Exchange Rate Movements

Tax Differentials
If the earnings from the project will someday be remitted to the parent, then the
MNC needs to consider how the parent’s government taxes these earnings. If the
parent’s government imposes a high tax rate on the remitted funds, the project may
be feasible from the subsidiary’s point of view but not from the parent’s point of
view.
Restrictions on remitted earnings:
Host governments may impose restrictions on remitted earnings by subsidiaries.
Consider a potential project to be implemented in a country where host government
restrictions require that a percentage of the subsidiary earnings remain in the country.
Because the parent may never have access to these funds, the project is not attractive to
the parent although it may be attractive to the subsidiary.

Exchange Rate Movements:

When earnings are remitted to the parent, the amount received by the parent is
influenced by the existing exchange rate. Therefore, a project that appears to be feasible
to the subsidiary may not be feasible to the parent if the subsidiary’s currency is
expected to weaken substantially over time.

Input for Multinational Capital Budgeting

 Initial investment
 Price and consumer demand
 Costs
 Tax laws.
 Remitted funds.
 Exchange rates
 Salvage (liquidation) value
 Required rate of return

Initial investment.
The parent’s initial investment in a project may constitute the major source of funds to
support a particular project. Funds initially invested in a project may include not only
those necessary to start the project but also additional funds, such as working capital, to
support the project over time. Such funds are needed to finance inventory, wages, and
other expenses until the project begins to generate revenue.

Price and consumer demand.

The price at which the product could be sold can be forecast using competitive products
in the markets as a comparison. The future prices will most likely be responsive to the
future inflation rate in the host countryThus future inflation rates must be forecast in
order to develop projections of the product price over time.
When projecting a cash flow schedule, an accurate forecast of consumer demand for a
product is quite valuable. The future demand is usually influenced by economic
conditions, which are uncertain.

Costs
 Variable-cost forecasts can be developed from comparative costs of the
components (such as hourly labor costs and the cost of materials). Such costs
should normally move in tandem with the future inflation rate of the host
country. Even if the variable cost per unit can be accurately predicted, the
projected total variable cost (variable cost per unit times quantity produced) may
be wrong if the consumer demand is inaccurately forecast.
 Fixed costs are expenses that are not affected by consumer demand, so they can
be estimated without a forecast of that demand. Rent or leasing expense is an
example of a fixed cost.

Tax laws
 The tax laws affecting earnings generated by a foreign subsidiary or remitted to
the MNC’s parent vary among countries (see the chapter appendix for more
details). Because after-tax cash flows are necessary for an adequate capital
budgeting analysis, international tax effects must be considered when assessing
the feasibility of any proposed foreign projects.

Remitted funds.
 The MNC’s policy for remitting funds to the parent is relevant input because it
influences the estimated cash flows generated by a foreign project that will be
remitted to the parent each period. In some cases, a host government will
prevent a subsidiary from remitting its earnings to the parent. If the parent is
aware of these restrictions, it can incorporate them when projecting net cash
flows

Exchange rates.
 Any international project will be affected by exchange rate fluctuations during
the life of the project, but these movements are usually difficult to forecast.
Although it is possible to hedge foreign currency cash flows, there is normally
much uncertainty surrounding the amount of those flows
 Salvage (liquidation) value.
 The after-tax salvage value of most projects will depend on several factors,
including the success of the project and the attitude of the host government
toward the project. Some projects have indefinite lifetimes that can be difficult to
assess; other projects have designated specific lifetimes, following which they will
be liquidated. This makes the capital budgeting analysis easier to apply. The MNC
does not always have complete control over the lifetime decision. In some cases,
political events may force the firm to liquidate the project earlier than

Required rate of return.

 Once the relevant cash flows of a proposed project are estimated, they can be
discounted at the project’s required rate of return. The MNC should first estimate
its cost of capital, after which it can derive its required rate of return on a project
based on the risk of that project. If a particular project has higher risk than other
operations of the MNC, then the required return on that project should be higher
than the MNC’s cost of capital.

Other Factors to Consider

 exchange rate fluctuations,
 Inflation
 Financing arrangement,
 Blocked funds,
 Uncertain salvage value,
 Impact of project on prevailing cash flows,
 Host government incentives, and
 Real options
Adjusting Project Assessment for Risk
 If an MNC is unsure of the estimated cash flows of a proposed project,
it needs to incorporate an adjustment for this risk. Three methods are
commonly used to adjust the evaluation for risk:
 ■ risk-adjusted discount rate,
 ■ sensitivity analysis, and
 ■ simulation

 Risk-Adjusted Discount Rate:

The greater the uncertainty about a project’s forecasted cash flows, the larger
should be the discount rate applied to the cash flows (other things being equal).
The application of a risk-adjusted discount rate is easy, but is criticized for being
somewhat arbitrary. Some managers might use a higher discount rate than other
managers for a particular project with a given level of expected cash flows.
Hence, the project might be feasible when assessed by some managers but
rejected when assessed by other managers

Sensitivity Analysis:
 Once the MNC has estimated the NPV of a proposed project, it may want to
consider alternative estimates for its input variables. Sensitivity analysis can be
more useful than simple point estimates because it reassesses the project based
on various circumstances that may occur.

Simulation:
Simulation can be used for a variety of tasks, including the generation of a
probability distribution for NPV based on a range of possible values for one or more
input variables. Simulation is typically performed with the aid of a computer package
Notes
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