International Financial Management

International Financial Mgmt

If a company has monetary assets denominated in
a foreign currency, it is exposed to the risk of
exchange rate fluctuations.

Purchasing power parity is an application of the
assumption that free markets do not allow
arbitrage opportunities to exist for long. Law of
one price

Exchange rates portray relationships in wealth
exchanges across national borders in much the
same manner as interest rates portray wealth
exchanges across time.
Exchange Rates
Imperfections
Frictions include:

Transaction Cost

Information Costs

Perishability

Even with its imperfections, there is an impressive

elegance and consistency in exchange rates across
currencies based on the general economics of
international transactions.
Forward Exchange Rates

By entering a forward exchange contract, a trader

commits to purchase or sell an amount of currency at a
fixed rate at a fixed time in the future.

The same result can be achieved by borrowing in the
foreign currency, exchanging spot and investing the
proceeds in the domestic currency. See example on
page 11/7
Interest Rate Parity

Interest rate parity ensures that borrowing or lending in
one currency at the interest rates applying to that currency
will produce the same final wealth as borrowing or lending
in any other currency at the interest rates applying to the
other currencies. Stated that way, the concept is almost self
evidently necessary: interest rates must adjust to ensure
such parity or there will be arbitrage opportunities.

Relative interest rates = Relative forward exchange discount
or premium
Forward Exchange, Interest Rates
and Inflation Expectations

Maintaining purchasing power across time
requires that the forward exchange rates for any
two currencies be consistent with the inflation
expected in those currencies.

Nominal interest rate = Real interest rate + Effect of
inflation

(1 + nominal rate)n = (1 + Real rate)n x (1 + inflation
rate)n

The connection is that interest rate differentials
are caused by inflation differentials, which are the
root cause of the observed discount or premium on
forward exchange.
Hedging International Cash Flows

Forward Contract

Covered Borrowing

Foreign Exchange Options
Investing in Foreign Real Assets

The basic process of deciding upon the financial viability of a foreign
investment is the same as a domestic one: estimate the expected cash
flows from the investment and discount at the investment’s cost of
capital (or use the cost of capital as a hurdle rate for IRR analysis).
1. It can predict future exchange rates between sterling and Euro, apply
those to the Euro future cashflow estimates, and discount future
sterling cash flows to the present at the sterling discount rate.
2. Or it can discount future Euro cashflow estimates at the Euro discount
rate and translate these Euro values to sterling values using the spot
exchange rate.
Extra risks in foreign investment
Financial Sources for Foreign
Investment

Monetary assets are those whose returns are
expected to be fixed in monetary or money terms
in the future, regardless of the inflation rate in the
economy.

Only these are serious candidates for the hedging of
exchange risk.

Real assets are not fixed in foreign currency
value, but will increase in value with increases in
foreign inflation.

This applies to plant and equipment, but also other
longer-term productive assets.