Cº - Imba International Finance (E) Part 1 Lecture

Bremen
London
 IMBA
   
Marseille
International Master of Business Administration
Moscow
Valencia
Core Module
INTERNATIONAL FINANCE
Part 1 Global Economics

AGENDA
Part 2 International Accounting
Part 3 Corporate Governance
Part 4 International Investing
Part 5 International Financing
Part 6 Global Value Creating Management
Part 7 Current Topics
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IMBA International Finance (E) Part 1 Lecture Part 1 Global Economics
AGENDA
Chapter 1.1 Globalization Process
Chapter 1.2 Foreign Exchange Theory Markets
Chapter 1.3 Foreign Exchange Market
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THE GLOBALIZATION PROCESS: Global Transition I
The globalization process is the structural and managerial
changes and challenges experienced by a firm as it moves from
domestic to global in operations
• Global Transition I = Trident moves from the domestic
phase to the international trade phase
Global Transition I - Phase One: Domestic Operations
U.S. Suppliers U.S. Buyers

(domestic) All payments in US $; (domestic)
All credit risk under U.S. law
Trident Corporation
(Los Angeles, USA)
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Trident may not be global or international itself, yet its
competitors, suppliers & buyers may be working across borders
This is often a key driver to push a firm like Trident into first
phase – international trade
•
The second half of this phase (Global transition I) is the
international trade phase
Global Transition I - Phase
Two: Expansion into Trident Corporation
International Trade (Los Angeles, USA)
Mexican Suppliers Canadian Buyers
Are Mexican suppliers dependable? Are Canadian buyers creditworthy?

Will Trident pay US$ or Mexican pesos?
IMBA International Finance (E) Part 1 Lecture
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International Master of Business Administration Will payment be made in US$ or C$?
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TRIDENT CORP: INITIATION OF GLOBALIZATION
Global Transition I
Phase One: Domestic Operations

U.S. Suppliers U.S. Buyers
(domestic) All payments in US $; (domestic)
All credit risk under U.S. law
Trident Corporation
(Los Angeles, USA)
Mexican Suppliers Canadian Buyers
Are Mexican suppliers dependable? Are Canadian buyers creditworthy?

Will Trident pay US$ or Mexican pesos? Will payment be made in US$ or C$?
Phase Two: Expansion into International Trade
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Trident responds to globalization factors by importing

inputs from Mexican suppliers and making exports
sales to Canadian buyers
This stage is called the international trade phase
• Exporting and importing products increases the
demands and requirements of a domestic only
business
- The first is direct foreign exchange
risks borne by Trident → Trident may have
to quote prices and receive payments in
foreign currencies
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THE GLOBALIZATION PROCESS
Global Transition I: Risks
• Trident will now experience
significant risks from the daily
volatility in exchange rates
• Trident also faces risks
associated with credit quality
and evaluation of international
counterparts:
- This credit risk management
task is much more difficult
in international business as
buyers and suppliers are
new and subject to differing
business practices and legal
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THE GLOBALIZATION PROCESS:
Global Transition II
Is the move from the international trade phase to the
multinational phase
• If Trident is successful in international trade then the
time will come for the next step in the globalization
process
-Trident will eventually need to establish foreign
sales and services affiliates
-This step is followed by the establishment of
manufacturing operations or licensing agreements
abroad
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THE GLOBALIZATION PROCESS
Trident’s continued globalization will require it to
identify the sources of it competitive advantages
• This variety of strategic alternatives available to
Trident is called the foreign direct investment
sequence
- These alternatives include the creation of foreign
sales offices, licensing agreements, manufacturing,
etc.
Once Trident owns assets and enterprises in foreign
countries it has entered the multinational phase of
globalization
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FOREIGN DIRECT INVESTMENT SEQUENCE
Trident and its
Competitive Advantage Greater Foreign
Presence
Change Exploit Existing Competit.

Competitive Advantage Advantage Abroad
Production at Home:
Production Abroad
Exporting
Licensing Control Assets

Management Contract Abroad
Greater
Wholly-Owned
Foreign Joint Venture
Subsidiary
Investmen
t
Greenfield Acquisition of a
Investment Foreign Enterprise
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FOREIGN EXCHANGE EXPOSURE
Due to the fact that more cash flows (CF) are
denominated in foreign currencies, Trident and other
corporations must manage these new exposures
• There are three main foreign exchange exposures that
must be managed by multinationals:
- Transaction Exposure comes from CF associated
from payments and receivables in foreign
currencies
- Operating Exposure comes from the changes in CF
caused by an unexpected change in exchange rates
- Translation Exposure is an accounting exposure
associated with the restatement of foreign currency
denominated financial statements
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FOREIGN EXCHANGE EXPOSURE
Moment in time when

exchange rate changes
Accounting exposure Operating exposure

Changes in reported owners’ equity Changes in CF due to unexpected
in consolidated financial statements changes in exchange rates
caused by a change in exchange rates
Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time
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FINANCING THE GLOBAL FIRM
As Trident prospers at home and abroad, it confronts
a constraint on further growth – access to cheap and
plentiful capital can be difficult
• This can be overcome by accessing global debt
and equity markets while maintaining an optimal
financial structure
• The strategy of globalizing the cost & availability
of capital is a critical one for firms wishing to
reach true global competitiveness
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FOREIGN INVESTMENT DECISIONS
Foreign investment decisions combine both strategy
and finance
This strategy of expanding operations abroad leads to a
corporation’s transition into a multinational enterprise
• An MNE is defined as a firm that has operating
subsidiaries in countries outside of its home
production & market
These firms also face evaluation of foreign located
projects using a capital budgeting framework
As Trident moves from a domestic operation towards a
MNE, it faces new & considerable risks & returns
dependent upon the strategies employed for its
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FOREIGN INVESTMENT DECISIONS
Trident Europe Trident Brazil Trident China

(Hamburg, Germany) (Sáo Paulo, Brazil) (Shanghai, China)
Cross-Border
Greenfield Acquisition Investment Joint Venture
Investment Investment
Trident Corporation
(Los Angeles, USA)
Greenfield Cross-Border Joint Venture

Investment Acquisition Investment
A long-term physical Identification, valuation, Combining investment
investment in productive tender, and post-acquisition capital and managerial
capability in that country management of an existing know-how to reach
going-concern specific opportunities
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FOREIGN INVESTMENT ISSUES
Other issues that firms face when expanding abroad

are
• Corporate Governance – the different corporate
cultures encountered when dealing with firms
abroad
• Global Portfolio Diversification – the
management of the risks and rewards needed to
understand the various foreign operations and
their effects on the domestic firm’s results
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MANAGING MULTINATIONAL OPERATIONS
Thus far the focus on Trident’s expansion into international
markets has been on operations and financing, but the aim of
management has not been addressed
Trident must also address the objective of maximizing
shareholder value. Then,
•Trident must minimize its worldwide burden of taxation
-Through transfer pricing (the prices charged on sales of
goods between units of Trident itself globally), Trident can
reduce its global tax liabilities
-Trident can also assess charges from the parent (US) to the
subsidiaries (foreign) in the form of license fees and royalties
-Trident must also consider the cash flow effects of blocked
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THE GOAL OF MANAGEMENT
Two different points of view on the goal of
management
• The Anglo-American markets believe that a firm’s
objective should be to maximize shareholder
wealth
- These countries include the US, Canada,
Australia, United Kingdom
• Shareholder believes that markets are efficient
and that prices are correct
- Follow financial theory about markets’
efficiency, systematic and unsystematic risk
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• The Continental European and Japanese markets
believe that a firm’s objective should be to maximize
corporate wealth
- These countries include the EU, Japan and Latin
American countries
• Definition of corporate wealth is broader than Anglo-
American viewpoint that wealth is strictly financial
• A corporation’s role in wealth maximization includes
the firm’s technical, market and human resources
- Considerations as to the implications of strategic
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“Impatient Capital” “Patient Capital”
Shareholders Shareholders
Firm
(management) Main Bank Firm
(management)
Banks Employees The Non-Anglo-American Model

has come under increasing criticism
The Anglo-American Model has for its lack of accountability to equity
been frequently criticized as investors – its shareholders – while
focusing on short-term profitability focusing on the demands of too
rather than long-term growth. diffuse a group of stakeholders.
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CORPORATE GOVERNANCE
These two approaches focus around the issue of
corporate governance
• Corporate Governance is the method by which an
organization establishes order among various
stakeholders to ensure that decisions are made &
interests are represented in line with the firm’s stated
objectives
- These include failure’s (Enron), poor performance
(AT&T), and emerging markets (China)
• As a result, companies are moving towards model of
“one share, one vote” in their corporate structures
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MINI - CASE
CORPORATE GOBERNANCE AT BRASIL

TELECOM
Individual Work
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TELECOM
1. What do you believe a government expects to gain
from privatizing major sectors like telecommunications?
Privatization is often conducted in pursuit of both political and
economic goals.
Politically, the recent trend globally has been toward market-
based economies, in which government ownership is to be
minimized.
Economically, privatization is considered by many emerging
market countries as a significant way of raising capital and
building globally competitive institutions and industries.
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TELECOM
1. What do you believe a government expects to gain
from privatizing major sectors like telecommunications?
In the case of Brasil and the telecommunications sector, the
privatization auction raised an enormous amount of
capital, as well as attracting foreign owners with world
class experience in that specific industry.
The hope was that owners like Telecom Italia would
provide capital, technology, and managerial expertise to
take the Brazilian telecom industry forward into the 21st
century.
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TELECOM
2. Why would two major investors like CVC/Opportunity and
Telecom Italia create a partnership to gain control of a firm and
then be unable to agree on the firm’s future strategy?
As is often the case with joint ventures and strategic alliances,
the initial motivations for the partnership are not the same as
the long-term strategies of the individual players.
Alone, either of the two parties could not have obtained the capital or
political links necessary to take control.
However, CVC/Opportunity is primarily interested in building the
profitability of BT itself over time, whereas Telecom Italia sees BT as
only one element of a much larger and complex strategy for
telecommunications industry penetration in Latin America as a
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TELECOM
3. If you were in management at Brasil Telecom, how
would the fighting between your owners alter your ability
to do your job? What could you do to ‘manage your
owners’?
The tendency among most larger firms is for management to
either make all major decisions or guide ownership’s interest
in those decisions.
BT’s management, if it were to focus its attention on a daily
basis on the disagreements among its owners, would find
itself standing still.
‘Managing owners’ is a difficult and dangerous process of
management.
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TELECOM
3. If you were in management at Brasil Telecom, how
would the fighting between your owners alter your ability
to do your job? What could you do to ‘manage your
owners’?
In the case of Brasil Telecom, it appeared from the very
beginning that Telecom Italia would not be a long-term
owner, and most of management had therefore sided with
CVC/Opportunity for expedient reasons.
Management will typically try to ignore it to whatever degree
possible, and prevent ownership’s divided input from
entering daily management and leadership.
Unfortunately, for major strategic and capital decisions such
as the rate at which BT is to fulfill infrastructure obligations,
the owners must be involved.
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TELECOM
4. If you were a minority investor in Brasil Telecom, holding some
of the publicly-traded shares, what rights do you believe you
should have in the ownership-control debate?
Minority shareholder rights is a very controversial subject in global
business today.
Many countries have enacted complex laws to protect minority
shareholders. (For example, in many countries like France a corporate
raider may not acquire more than 30% ownership of the publicly traded
shares without making a public tender offer to all remaining
shareholders.)
Most minority shareholders will realize that they will not have any real
voice in the future direction of the firm.
In this case, minority investors are increasingly passive owners. The
debate, can, however, become increasingly complex as foreign
ownership like Telecom Italia starts appearing to abuse the rights of
domestic investors – minority investors and major investors – adding
fuel to the fire of public debate.
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AGENDA
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CURRENCY TERMINOLOGY
• A foreign currency exchange rate, or exchange rate,
is the price of one country’s currency in units of
another country’s currency
- The system, or regime, is classified as a fixed,
floating, or managed exchange rate regime
- The rate at which the currency is fixed, or
pegged, is frequently referred to as its par value
- If the government doesn’t interfere in the
valuation of its currency, the currency is
classified as floating or flexible
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Spot exchange rate is the quoted price for the foreign
exchange (FX) to be delivered at once, or in 2 days for
interbank transactions
Example:(1)
• ¥114/$ ⇒ $ 1 = ¥ 114: is quoted for 114 yen to
buy one US $ for immediate delivery
Devaluation (≠ Depreciation) of a currency refers to a
drop in FX value of a currency that is pegged to gold or
to another currency. The par value is reduced, the
opposite of devaluation is revaluation
(1) Sources for currency quotations;
http://www .bloomberg.com/markets/currencies/fxc.html
http://www .reuters.com/financeCurrencies.jhtml
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Backup
Current Quotations
U.S. $ ¥en Euro Can $ U.K. £ Aust $ SFranc
1 US $ = 1.000 109.250 0.8098 1.329 0.5497 1.348 1.269
1 ¥en = 0.009153 1.000 0.007405 0.0122 0.005029 0.0123 0.0116
1 Euro = 1.234 134.910 1.000 1.641 0.6786 1.664 1.567
1 Can $ = 0.7523 82.070 0.6080 1.000 0.4131 1.013 0.9542
1 UK £ = 1.819 198.750 1.472 2.418 1.000 2.452 2.309
1 Aust $ = 0.7414 80.980 0.6001 0.9860 0.4074 1.000 0.9406
1 SFranc = 0.7878 86.070 0.6375 1.046 0.4327 0.9406 1.000
Source: www.reuters.com/financeCurrencies.jhtml 16 March 2004
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Weakening, deteriorating, or depreciation of a currency
refers to a drop in foreign exchange value a floating
currency. The opposite of weakening is strengthening
or appreciating, which refers to a gain in the exchange
value of a floating currency.
Soft or weak describes a currency that we expect to
devalue or depreciate relative to major currencies; hard
or strong is the opposite.
Eurocurrencies are another type of money although in
reality they are domestic currencies of a country
deposited in another country.
• Example: a Euro$ is a US $ denominated deposit in a
bank outside of the United States
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ATTRIBUTES OF THE “IDEAL” CURRENCY
Exchange rate stability – the value of the currency would
be fixed in relationship to other currencies so traders &
investors could be relatively certain of the FX value of
each currency in the present & near future
Full financial integration – complete freedom of
monetary flows would be allowed, so traders and
investors could willingly and easily move funds from
one country to another in response to perceived
economic opportunities or risk
Monetary independence– domestic monetary & interest
rate policies would be set by each individual country to
pursue desired national economic policies, especially as
they might relate to limiting inflation, combating
recessions and fostering prosperity & full employment
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Full Capital Controls
Monetary Exchange
Independence Rate Stability
Increased
Capital Mobility
Pure Float Monetary Union

Full Financial
Integration
A country is limited to only two-sides per system. For example, if
a nation wishes to pursue Monetary Independence and Full
Financial Integration, it cannot simultaneously attain Exchange
Rate Stability.
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This is referred to as The Impossible Trinity because

a country must give up one of the 3 goals described
by the sides of the triangle, monetary independence,
exchange rate stability, or full financial integration.
The forces of economics do not allow the
simultaneous achievement of all 3
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INTERNATIONAL PARITY CONDITIONS
The economic theories which link exchange rates,

price levels, and interest rates together are called
international parity conditions
These theories may not always work out to be “true”
when compared to what students and practitioners
observe in the real world, but they are central to any
understanding of how markets run & multinational
business is conducted
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PRICES AND EXCHANGE RATES
The Law of one price states that all else being equal
(no transaction costs) a product’s price should be the
same in all markets
Even if prices for a particular product are in different
currencies, the law of one price states that
P$ × S = P¥
Where:
The price of the product in US $ (P$), multiplied by the spot
exchange rate (S, ¥ per $), equals the price of the product in
Japanese ¥ (P¥)
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PRICES AND EXCHANGE RATES
Conversely, if the prices were stated in local
currencies, and markets were efficient, the
exchange rate could be deduced from the relative
local product prices
γ
P
S =
P $
Where: γ = ¥
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PURCHASING POWER PARITY (PPP) &
THE LAW OF ONE PRICE
If the Law of One Price were true for all goods, the
purchasing power parity (PPP) exchange rate could
be found from any set of prices
Through price comparison, prices of individual
products can be determined through the PPP
exchange rate
This is the absolute theory of PPP
• Absolute PPP states that the spot exchange rate
is determined by the relative prices of similar
basket of goods
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THE BIG MAC HAMBURGER STANDARD
The Economist developed the Big Mac Standard to
track PPP:
• Assuming that a Big Mac is identical in all countries,
it serves as a comparison point as to whether or not
currencies are trading at market prices
• Big Mac in Switzerland costs Sfr6.30 while the same
Big Mac in the US costs $2.54
• The implied PPP of this exchange rate is
Sfr6.30
= Sfr2.4803/$
$2.54
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THE BIG MAC HAMBURGER STANDARD
However, on the date of the survey, the actual
exchange rate was Sfr1.73/$, therefore the Swiss
franc ($) is overvalued (undervalued) by:
Sfr2.4803
= 1.4337 or ≈ + 43.37%
Sfr1.73
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RELATIVE PURCHASING POWER PARITY
If the assumptions of absolute PPP theory are relaxed,
we observe relative purchasing power parity
• This idea is that PPP is not particularly helpful in
determining what the spot rate is today, but that the
relative change in prices between countries over a
period of time determines the change in exchange
rates
• Moreover, if the spot rate between 2 countries starts
in equilibrium, any change in the differential rate of
inflation between them tends to be offset over the
long run by an equal but opposite change in spot rate
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INTEREST RATES AND EXCHANGE RATES
Prices between countries are related by exchange
rates and now we discuss how exchange rates are
linked to interest rates
The Fisher Effect states that nominal interest rates in
each country are equal to the required real rate of
return plus compensation for expected inflation. As a
formula, the Fisher Effect is:
(1 + i) = (1 + r) x (1 + π ) ⇒ i = r +π + rπ
• Where i is the nominal rate, r is the real rate of interest, and π is
the expected rate of inflation over the period of time
• The cross-product term, r π, is usually dropped due to its
relatively minor value
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Applied to 2 different countries, like the US and Japan,
the Fisher Effect would be stated as
$ $ $ ¥ ¥ ¥
i = r +π ; i = r +π
It should be noted that this requires a forecast of the

future rate of inflation, not what inflation has been, and
predicting the future can be difficult!
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The international Fisher effect, or Fisher-open, states
that the spot exchange rate should change in an
amount equal to, but in the opposite direction, of the
difference in interest rates between countries
• if we were to use the US $ and the Japanese ¥, the
expected change in the spot exchange rate between
the $ and ¥ should be (in approximate form):
S −S
x 100 = i − i
1 2 $ ¥
S 2
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Justification for the international Fisher effect is that

investors must be rewarded or penalized to offset the
expected change in exchange rates
The international Fisher effect predicts that with
unrestricted capital flows, an investor should be
indifferent between investing in $ or ¥ bonds, since
investors worldwide would see the same opportunity
and compete it away
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The Forward Rate
• A forward rate is an exchange rate quoted today
for settlement at some future date
• The forward exchange agreement between
currencies states the rate of exchange at which
a foreign currency will be bought or sold
forward at a specific date in the future (typically
30, 60, 90, 180, 270 or 360 days)
• The forward rate is calculated by adjusting the
current spot rate by the ratio of euro currency
interest rates of the same maturity for the two
subject currencies
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The Forward Rate
  90  
 1 +  i x  
FC
  360  
F FC/$
=S FC/$
x
  90  
90
 1 +  i x 
$
  360  
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The Forward Rate example with spot rate of Sfr1.4800/$,
a 90-day euro Swiss franc deposit rate of 4.00% p.a. (per
annum) and a 90-day euro-$ deposit rate of 8.00% p.a.
  90 
 1 +  0.400 x 360 
Sfr/$
F90 = Sfr1.4800 x
  = Sfr1.4800 x
1.01
= Sfr1.4655/$
  90  1.02
 1 +  0.800 x 360 
 
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The forward premium or discount is the percentage
difference between the spot and forward rates stated in
annual percentage terms
Foward - Spot 360

f FC
= x x 100
Spot days
For direct (indirect) quotes ($/FC, home currency per foreign
currency unit) (FC/$, foreign currency per home currency
units) ⇒ The valued or quoted Currency is FC (Foreign
Currency) (Home currency = $):
• F > S ⇒ Premium Forward of quoted currency
• F < S ⇒ Discount Forward of quoted currency
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Using the previous Sfr example, the forward
discount or premium would be as follows:
Spot - Foward 360

f FC
= x x 100
Foward days
Sfr1.4800 - Sfr1.4655 360
f Sfr
= x x 100 = + 3.96% p.a.
Sfr1.4655 90
The positive sign indicates that the Swiss franc is selling
forward at a premium of 3.96% per annum (it takes 3.96%
more $ to get a franc at the 90-day forward rate)
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INTEREST RATE PARITY (IRP)
• IRP theory provides the linkage between foreign
exchange markets and international money markets
• The theory states that the difference in the national
interest rates for securities of similar risk and
maturity should be equal to, but opposite sign to, the
forward rate discount or premium for the foreign
currency, except for transaction costs
• In the diagram in the following slide, a US $-based
investor with $1 million to invest, is shown
indifferent between $-denominated securities for 90
days earning 8.00% per annum, or Swiss franc-
denominated securities of similar risk and maturity
earning 4.00% per annum, when “cover” against
currency risk is obtained with a forward contract I MBA
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INTEREST RATE PARITY (IRP)
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000 × 1.02 $1,020,000
Dollar money market $1,019,993*
S = SF 1.4800/$ 90 days F90 = SF 1.4655/$
Swiss franc money market
SF 1,480,000 × 1.01 SF 1,494,800
i SF = 4.00 % per annum

(1.00 % per 90 days)
•Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
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EXCHANGE RATE DETERMINATION (I)
Three basic approaches
• Parity conditions
• Balance of Payments
• Asset market
These theories are not competing theories but
complimentary ones.
Along with an understanding of the theories, an
understanding of the complexities of international
political economy, societal and economic
infrastructures, and random political and social events
is needed when viewing the foreign exchange markets.
I MBA
 
56
EXCHANGE RATE DETERMINATION (II)
Infrastructure weaknesses were among the major

causes of the exchange rate collapses in emerging
markets in the late 1990s.
Speculation contributed greatly to the emerging
market crises.
Uncovered interest rate arbitrage caused by extremely
low interest rates in Japan coupled with high real
interest rates in the US was a problem in the 1990s.
I MBA
 
57
EXCHANGE RATE DETERMINATION (III)
Cross-border foreign direct investment and
international portfolio investment into emerging
markets dried up during the recent crises.
Foreign political risks have been much reduced in
recent years as capital markets became less
segmented from each other and more liquid.
Finally, note that most determinants of spot exchange
rates are also in turn affected by changes in the spot
rate – in other words, they are not only linked but
mutually determined.
I MBA
 
58
EXCHANGE RATE DETERMINATION (IV)
Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Interest rate parity
Is there a sound and

Is there a well-developed
secure banking system
and liquid money and Spot in-place to support
capital market in that
Exchange currency trading
currency?
Rate activities?
Asset Approach
Balance of Payments
1. Relative interest rates
1. Current account balances
2. Prospects for economic growth
2. Portfolio investment
3. Supply & demand for assets
3. Foreign direct investment
4. Outlook for political stability
4. Exchange rate regimes
5. Speculation & liquidity
5. Official monetary reserves
6. Political risks & controls I MBA
 
59
FORECASTING IN PRACTICE (I)
Short-term forecasts are typically motivated by a

desire to hedge a receivable, payable, or dividend for
perhaps a period of 3 months.
• Here, long run economic fundamental
analysis may not serve the purpose as
well as technical factors in the
marketplace, government
intervention, news and passing
whims of traders and investors.
I MBA
 
60
FORECASTING IN PRACTICE (II)
Forecast Period Regime Recommended Forecast Methods: Variables to consider
SHORT-RUN Fixed Rate 1. Assume fixed rate is maintained

2. Indications of stress on fixed rate?
3. Capital controls, black market rates
4. Indicators of government's capability to maintain fixed rate?
5. Changes in official reserves
SHORT-RUN Floating Rate 1.Technical methods which capture trend

2. Forward rates as forecasts
a. <30 days, assume random walk
b. 30-90 days, forward rates
3. 90-360 days, combine trend with fundamental analysis
4. Fundamental analysis of inflationary concerns
5. Government declarations and agreements regarding exchange rate goals
6. Cooperative agreements with other countries
I MBA
 
61
FORECASTING IN PRACTICE (III)
Forecast Period Regime Recommended Forecast Methods: Variables to consider
LONG-RUN Fixed Rate 1. Fundamental analysis

2. BOP management
3. Ability to control domestic inflation
4. Ability to generate hard currency reserves to use for intervention
5. Ability to run trade surpluses
LONG-RUN Floating Rate 1.Focus on inflationary fundamentals and PPP

2. Indicators of general economic health such as economic growth and
stability
3. Technical analysis of long-term trends; new research indicates possibility
of long-term technical “waves”
I MBA
 
62
AGENDA
I MBA
 
63
FOREIGN EXCHANGE MARKETS (I)
The FOREX market provides the physical and institutional
structure through which the money of one country is exchanged
for that of another country.
A foreign exchange transaction is an agreement between a
buyer and a seller that a fixed amount of one currency will be
delivered for some other currency at a specified rate.
There are 6 main characteristics of the FOREX markets which
will be discussed:
• The geographic extent
• The 3 main functions
• The market’s participants
• Its daily transaction volume
• Types of transactions including spot, forward and swaps
• Methods of stating exchange rates, quotations, and changes
in exchange rates I MBA
 
64
GEOGRAPHIC EXTENT OF THE MARKET (I)
Geographically, the FOREX market spans the globe

with prices moving and currencies trading on a 24
hour basis.
Major exchanges are located in Singapore, Hong
Kong and Tokyo in the East.
Then it moves to Bahrain, and London for the
European area.
And on to New York, San Francisco and Sydney.
I MBA
 
65
GEOGRAPHIC EXTENT OF THE MARKET (II)
Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
25.000
20.000
15.000
10.000
5.000
Greenwich Mean Time
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyoopening closing open closing in America In NY opens
I MBA
 
66
FUNCTIONS OF THE FOREX MARKET
The FOREX market is the mechanism by which participants
transfer purchasing power between countries, obtains or
provides credit for international trade, and minimizes exposure
to exchange rate risk.
• Transferring of purchasing power is necessary because
international trade and capital transactions normally
involve parties in countries with different currencies yet
each party wishes to transact in their own currency.
• Because the movement of goods between countries takes
time, inventory in transit must be financed. The FOREX
market provides a source of credit via specialized
instruments such as letters of credit.
• The FOREX market provides “hedging” facilities for
transferring foreign exchange risk to someone else more
willing to carry that risk. I MBA
 
67
MARKET PARTICIPANTS
The FOREX market consists of 2 tiers, the interbank or
wholesale market, and the client or retail market.
5 broad categories of participants operate within these
2 tiers:
• Bank and non bank foreign exchange dealers.
• Individuals and firms conducting commercial or
investment transactions.
• Speculators and arbitragers.
• Central banks and treasuries.
• Foreign exchange brokers.
I MBA
 
68
BANK AND NON-BANK DEALERS (I)
These participants profit from buying currencies at a
bid price and then reselling them at an offer or ask
price.
Competition among dealers narrows the spread
between the bid and offer rate contributing to the
market’s efficiency.
Dealers on behalf of large international banks often act
as market makers, often willing to stand in and buy or
sell these currencies without having a counterpart with
which to unload the “inventory”.
I MBA
 
69
BANK AND NON-BANK DEALERS (II)
They trade amongst other banks and dealers in order

to keep their inventory levels at manageable levels.
Currency trading is profitable and often contributes
between 10% - 20% of a banks’ average net income.
Small- to medium-sized banks rarely act as market
makers yet still participate in the interbank market.
I MBA
 
70
INDIVIDUALS AND FIRMS CONDUCTING
COMMERCIAL/INVESTMENT TRANSACTIONS
Importers, exporters, portfolio investors, MNEs,

tourists and others use the FOREX market to facilitate
execution of commercial or investment transactions.
Some of these participants use the market to hedge
foreign exchange rate risk.
I MBA
 
71
SPECULATORS AND ARBITRAGERS
Speculators and arbitragers seek to profit from trading
in the market itself.
They operate for their own interest, without need or
obligation to serve clients or ensure a continuous
market.
Speculators seek all their profit from exchange rate
changes.
Arbitragers try to profit from simultaneous differences
in exchange rates in different markets.
A large proportion of speculation and arbitrage is
conducted on behalf of major banks by traders
employed by those banks. I MBA
 
72
CENTRAL BANKS AND TREASURIES
Central banks and treasuries use the market to
acquire or spend their country’s currency reserves
as well as to influence the price at which their own
currency trades.
They may act to support the value of their currency
because of their government’s policies or
obligations or because of commitments entered
through joint float agreements such as the European
Monetary System (EMS).
Consequently their motive is not to profit but rather
influence the foreign exchange value of their
currency in a manner that will benefit their interests.
I MBA
 
73
FOREIGN EXCHANGE BROKERS
Foreign exchange brokers are agents who facilitate

trading between dealers without themselves
becoming principals in the transaction.
For this service they charge a small commission.
They maintain instant access to hundreds of dealers
worldwide via open lines and at times may maintain
such lines with several banks, with separate lines for
differing currencies, spot and forward rates.
I MBA
 
74
TRANSACTIONS IN THE INTERBANK MARKET
Transactions within this market can be executed on
a spot, forward, or swap basis
• A spot transaction requires almost immediate
delivery of foreign exchange
• A forward transaction requires delivery of
foreign exchange at some future date
• A swap transaction is the simultaneous
exchange of one foreign currency for another
I MBA
 
75
SPOT TRANSACTIONS
A spot transaction in the interbank market is the

purchase of foreign exchange, with delivery
and payment between banks to take place,
normally, on the second following business day
• The settlement date is often referred to as
the value date.
• This is the date when most dollar
transactions are settled through the
computerized Clearing House Interbank
Payment Systems (CHIPS) in New York.
I MBA
 
76
OUTRIGHT FORWARD TRANSACTIONS
This transaction requires delivery at a future value date
of a specified amount of one currency for another.
The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed.
Forward rates are contracts quoted for value dates of
one, two, three, six, nine and twelve months
• Terminology typically used is buying or selling
forward.
• A contract to deliver $ for € in 6 months is both
buying € forward for $ and selling $ forward for €.
I MBA
 
77
SWAP TRANSACTIONS (I)
A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
Both purchase and sale are conducted with the same
counterpart.
A common type of swap is a spot against forward
• The dealer buys a currency in the spot market
and simultaneously sells the same amount back
to the same bank in the forward market.
• Since this transaction occurs at the same time
and with the same counterpart, the dealer incurs
no exchange rate exposure.
I MBA
 
78
SWAP TRANSACTIONS (II)
Forward-forward swaps:
A dealer sells £20,000 forward for $ for delivery in 2
months at $1.6870/£ and simultaneously buys
£20,000 forward for delivery in 3 months at $1.6820/£
• The difference between the buying and selling
price (0.0050) is equivalent to the interest rate
differential.
• Thus a swap can be viewed as a technique for
borrowing another currency on a fully
collateralized basis.
I MBA
 
79
SWAP TRANSACTIONS (III)
Non-deliverable forwards (NDFs):
NDFs possess the same characteristics as traditional
forward contracts except that they are settled only in
US $ and the foreign currency being sold or bought
forward is not delivered
• The dollar-settlement feature reflects the fact
that NDFs are contracted offshore and are
beyond the reach and regulatory frameworks of
the home country governments.
• Pricing of NDFs reflects basic interest rate
differentials.
I MBA
 
80
SIZE OF THE FOREX MARKET (I)
The Bank for International Settlements (BIS)

estimates that daily global net turnover in traditional
FOREX market activity to be US$ 1,210 billion in April
2001.
I MBA
 
81
SIZE OF THE FOREX MARKET (II)
Global Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
800
700 Spot
Forwards
600 Swaps
500
400
300
200
100
0
1989 1992 1995 1998 2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign

Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org.
I MBA
 
82
SIZE OF THE FOREX MARKET (III)
Two of the three categories fell between 1998 and 2001
with spot market daily turnover falling the most, from
$568 billion in 1998 to $387 billion in 2001.
Forward transactions increased slightly from $128
billion in 1998 to $131 billion in 2001.
Swaps fell to $656 billion in 2001 from $734 billion in
1998
• BIS attributes the introduction of the €, the
growing share of electronic broking in the spot
market and consolidation in banking as
explanations for the reduction.
I MBA
 
83
SIZE OF THE FOREX MARKET (IV)
Geographic Distribution of Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
700 United States
United Kingdom
600
Japan
500 Singapore
Germany
400
300
200
100
0
1989 1992 1995 1998 2001
Exchange and Derivatives. Market Activity in April 2001,” October 2001, www.bis.org.
I MBA
 
84
SIZE OF THE FOREX MARKET (V)
Currency Distribution of Global Foreign Exchange Market Turnover
(percentage shares of average daily turnover in April)
US dollar
90
EURO
80
Deutsche Mark
70 French franc
60 EMS currencies
Japanese yen
50
Pound sterling
40 Swiss franc
30
20
10
0
1989 1992 1995 1998 2001

Exchange and Derivatives. Market Activity in April 2001,” October 2001, www.bis.org.
I MBA
 
85
FOREIGN EXCHANGE RATES & QUOTATIONS (I)
A foreign exchange quote is a statement of willingness
to buy or sell at an announced rate
• In the retail market (newspapers and exchange
booths), quotes are often given as the home currency
price of the foreign currency.
• Interbank quotes – professionals state forex quotes
in one of two ways $ 1 = Sfr 1.6000
-The foreign currency price of one $
· Sfr1.6000/$, read as 1.600 Swiss francs per $.
Sfr 1 = $ 0.625
-The $ price of a unit of foreign currency
· $0.6250/Sfr, read as 0.625 $ per Swiss franc.
I MBA
 
86
FOREIGN EXCHANGE RATES & QUOTATIONS (II)
$ 1 = Sfr 1.6000
The former quote (Foreign currency price of one $) is

considered the “European quote” and the latter ($ price
of a unit of foreign currency) is the “American quote”.
Sfr 1 = $ 0.625
Almost all European currencies, except two, are quoted
the European way
• The Sterling Pound and the € are the exceptions.
• Additionally, Australian and New Zealand $ are
also quoted in American terms.
I MBA
 
87
FOREIGN EXCHANGE RATES & QUOTATIONS
(III)
Direct and Indirect Quotes
• A direct quote is a home currency price of a
unit of a foreign currency $ 1 = Sfr 1.6000
- Sfr1.6000/$ is a direct quote in Switzerland.
• An indirect quote is a foreign currency price in
a unit of the home currency $ 1 = Sfr 1.6000
- Sfr1.600/$ is an indirect quote in the US,
- $0.625/Sfr is a direct quote in the US and an
indirect quote in Switzerland. Sfr 1 = $ 0.625
Sfr 1 = $ 0.625 is the
reciprocal of $ 1 = Sfr 1.6000
I MBA
 
88
(IV)
Bid and Ask Quotations
• Interbank quotes are given as a bid and ask
- The bid is the price at which a dealer will buy a
currency
- The ask or offer is the price at which a dealer will
sell a currency
· Example: ¥118.27 - ¥118.37/$ is the bid/ask for
Japanese yen
· The bank will buy $ (sell ¥) at ¥118.27 per $
and sell $ (buy ¥) at ¥118.37 per $ making
profit on the spread I MBA
 
89
(V)
Expressing Forward Quotations on a Points Basis
• The previously mentioned rates for yen were
considered outright quotes.
• Forward quotes are different and typically
quoted in terms of points.
• A point is the last digit of a quotation, with
convention dictating the number of digits to
the right of the decimal.
- Hence a point is equal to 0.0001 of most
currencies.
I MBA
 
90
(VI)
Expressing Forward Quotations on a Points Basis
• The yen is quoted only to two decimal points.
• A forward point basis quotation is not a foreign
exchange rate, rather the difference between
the spot and forward rates.
• Example: It’s possible: + or – ⇒
Bid Ask Premium or discount
of the quoted currency
Outright spot: ¥118.27 ¥118.37
Plus points (3 months) -1.43 -1.40
Outright forward: ¥116.84 ¥116.97
I MBA
 
91
(VII)
Forward Quotations in Percentage Terms
• Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate.
- This is similar to the forward discount or
premium calculated earlier.
• The important thing to remember is which currency
is being used as the home or base currency: the
quoted currency.
- For direct quotes (i.e. quote expressed in home
currency terms = The foreign currency is quoted),
the formula is: H Forward - Spot 360
f = x x 100
Spot days
I MBA
 
92
(VIII)
Forward Quotations in Percentage Terms
• Example: Indirect quote Spot: $ 1 = ¥ 105.65
Forw: $ 1 = ¥ 105.04
¥ 105.65 - 105.04 360
f = x x 100 = + 2.32% p.a. Reciprocals
105.04 90
Spot: ¥ 1 = $ 0.009465215
• Example: Direct quote Forw: ¥ 1 = $ 0.009520183
0.009520183 - 0.009465215 360

f = $
x x 100 = + 2.32% p.a.
0.009465215 90
2.32% = ¥’s premium = $’s discount forward (3 months)

I MBA
 
93
(IX)
Cross Rates
• Many currencies pairs are inactively traded, so their
exchange rate is determined through their
relationship to a widely traded third currency.
• Example: A Mexican importer needs Japanese yen
(¥) to pay for purchases in Tokyo. Both the Mexican
peso (Ps) and ¥ are quoted in US $.
- Assume the following quotes:
Japanese yen ¥ 121.13/$ ⇒ $ 1 = ¥ 121.13
Mexican peso Ps 9.190/$ ⇒ $ 1 = Ps 9.190
I MBA
 
94
(X)
Cross Rates
• The Mexican importer can buy one US dollar for Ps9.190
and with that dollar buy ¥121.13; the cross rate would be:
Japanes yen/US dollar ¥ 121.13/$

= = ¥ 13.1806/PS
Mexican pesos/US dollar PS 9.190/$
$ 1 = ¥ 121.13 & $ 1 = Ps 9.190 ⇒
¥ 121.13 = Ps 9.190 ⇒
¥ 1 = 9.190 / 121.13 Ps = 0.075868901 Ps/¥
or Ps 1 = 121.13/ 9.190 ¥ = 13.18063112 ¥/Ps
I MBA
 
95
(XI)
Intermarket Arbitrage
• Cross rates can be used to check on
opportunities for intermarket arbitrage.
• Example: Assume the following exchange rates
are quoted.
Citibank $0.9045/€
Barclays Bank $1.4443/£
Dresdner Bank €1.6200/£
I MBA
 
96
(XII)
Intermarket Arbitrage
• The cross rate between Citibank and Barclays is
Citibank $0.9045/€ ⇒ $ 1 = 1 / 0.9045€
Barclays Bank $1.4443/£ ⇒ £ 1 = $ 1.4443 then, £ 1 =
$1.4443/£
= € 1.5968/ £
$0.9045/€
• This cross rate is not the same as Dresdner’s rate

quote of €1.6200/£, so an opportunity exists for risk-
less profit
I MBA
 
97
FOREIGN EXCHANGE RATES & QUOTATIONS (XIII)
Citibank
End with $1,014,533 Start with $1,000,000
(6) Receive $1,014,533 (1) Sell $1,000,000 to Barclays

Bank at $1.4443/£
Dresdner Bank Barclays Bank

(1) Sell €1,121,651 to Citibank (2) Receive £692,377
at $0.9045/€
(1) Sell £692,377 to Dresdner Bank
(4) Receive €1,121,651 at €1.6200/£
I MBA
 
98

Cº - Imba International Finance (E) Part 1 Lecture

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Cº - Imba International Finance (E) Part 1 Lecture

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Bremen

Part 1 Global Economics

Part 1 Global Economics

Part 2 International Accounting

Part 3 Corporate Governance

Part 4 International Investing

Part 5 International Financing

Part 6 Global Value Creating Management

Part 7 Current Topics

Part 1 Global Economics

Chapter 1.1 Globalization Process

Chapter 1.2 Foreign Exchange Theory Markets

Chapter 1.3 Foreign Exchange Market

U.S. Suppliers U.S. Buyers

Mexican Suppliers Canadian Buyers

Are Mexican suppliers dependable? Are Canadian buyers creditworthy?

Phase One: Domestic Operations

Mexican Suppliers Canadian Buyers

Are Mexican suppliers dependable? Are Canadian buyers creditworthy?

Trident responds to globalization factors by importing

Change Exploit Existing Competit.

Licensing Control Assets

Moment in time when

Accounting exposure Operating exposure

Trident Europe Trident Brazil Trident China

Greenfield Cross-Border Joint Venture

Other issues that firms face when expanding abroad

“Impatient Capital” “Patient Capital”

Banks Employees The Non-Anglo-American Model

CORPORATE GOBERNANCE AT BRASIL

Part 1 Global Economics

Chapter 1.1 Globalization Process

Chapter 1.2 Foreign Exchange Theory Markets

Chapter 1.3 Foreign Exchange Market

1 US $ = 1.000 109.250 0.8098 1.329 0.5497 1.348 1.269

1 ¥en = 0.009153 1.000 0.007405 0.0122 0.005029 0.0123 0.0116

1 Euro = 1.234 134.910 1.000 1.641 0.6786 1.664 1.567

1 Can $ = 0.7523 82.070 0.6080 1.000 0.4131 1.013 0.9542

1 UK £ = 1.819 198.750 1.472 2.418 1.000 2.452 2.309

1 Aust $ = 0.7414 80.980 0.6001 0.9860 0.4074 1.000 0.9406

1 SFranc = 0.7878 86.070 0.6375 1.046 0.4327 0.9406 1.000

Source: www.reuters.com/financeCurrencies.jhtml 16 March 2004

Pure Float Monetary Union

This is referred to as The Impossible Trinity because

The economic theories which link exchange rates,

It should be noted that this requires a forecast of the

Justification for the international Fisher effect is that

The Forward Rate

Foward - Spot 360

Spot - Foward 360

Dollar money market $1,019,993*

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000 × 1.01 SF 1,494,800

i SF = 4.00 % per annum

Infrastructure weaknesses were among the major

Is there a sound and

Short-term forecasts are typically motivated by a

Forecast Period Regime Recommended Forecast Methods: Variables to consider

SHORT-RUN Fixed Rate 1. Assume fixed rate is maintained

SHORT-RUN Floating Rate 1.Technical methods which capture trend

Forecast Period Regime Recommended Forecast Methods: Variables to consider