CHAPTE

INTERNATIONAL FINANCIAL MANAGEMENT

R 34
 LEARNING OBJECTIVES
2

 Understand how the foreign exchange market

operates.
 Explain the relationship between interest rates,
inflation rates and exchange rates.
 Focus on the techniques that can be used to hedge the
foreign exchange risk.
 Illustrate how the international capital budgeting
decisions are made.
 Highlight the methods of financing international
operations.
 THE FOREIGN EXCHANGE
3
MARKET
 The foreign exchange market is the market where the
currency of one country is exchanged for the currency
of another country. Most currency transactions are
channelled through the world-wide interbank market.
Interbank market is the wholesale market in which
major banks trade with each other.

 Participants
 Speculators
 Arbitrageurs
 Traders
 Hedgers
 Foreign Exchange Rates
4

 A foreign exchange rate is the price of one currency quoted in terms of

another currency.
 When the rate is quoted per unit of the domestic currency, it is referred
to as direct quote. Thus, the US$ and INR exchange rate would be
written as US$ 0.02538/INR.
 When the rate is quoted as units of domestic currency per unit of the
foreign currency, it is referred to as indirect quote.
 A cross rate is an exchange rate between the currencies of two countries
that are not quoted against each other, but are quoted against one
common currency.
 Suppose that German DM is selling for $ 0.62 and the buying rate for
the French franc (FF) is $ 0.17, what is the DM/FF cross-rate? It is:

US $ 0.62 FF FF 3.65
 
DM US $ 0.17 DM
 Foreign Exchange Rates
5
 The spot exchange rate is the rate at which a currency can be bought
or sold for immediate delivery which is within two business days after
the day of the trade.
 Bid-ask spread is the difference between the bid and ask rates of a
currency.
 The forward exchange rate is the rate that is currently paid for the
delivery of a currency at some future date.
 The forward rate may be at a premium or at a discount.
 For a direct quote, the annualised forward discount or premium can be
calculated as follows:
 Spot rate – Forward rate  360
Forward premium (discount)    
 Spot rate  Days
INTERNATIONAL PARITY
RELATIONSHIPS
6

 There are the following four international parity

relationships:
 Interest rate parity (IRP)
 Purchasing power parity (PPP)
 Forward rates and future spot rates parity
 International Fisher effect (IFE).
 Interest Rate Parity
7

 Itstates that the exchange rate of two countries will be affected

by their interest rate differential. In other words, the currency
of a high-interest-rate-country will be at a forward discount
relative to the currency of a low-interest-rate-country, and vice
versa. This implies that the exchange rate (forward and spot)
differential will be equal to the interest rate differential
between the two countries. That is:
Interest differential = Exchange rate (forward and spot)
differential

(1  rF ) f F / D

(1  rD ) sF / D
 Purchasing Power Parity
8

 In absolute terms, purchasing power parity states that the exchange rate
between the currencies of two countries equals the ratio between the
prices of goods in these countries. Further, the exchange rate must
change to adjust to the change in the prices of goods in the two
countries. In relative terms, purchasing power states that the exchange
rate between the currencies of the two countries will adjust to reflect
changes in the inflation rates of the two countries. In formal terms, it
implies that the expected inflation differential equals to the current spot
rate and the expected spot rate differential. Thus:
Inflation rate differential = Current spot rate and expected spot rate
differential

(1  iF ) E ( sF / D )

(1  iD ) sF / D
Expectation Theory of Forward
Rates
9

 The expectation theory of forward exchange rates states

that the forward rate provides the best and unbiased
forecast of the expected future spot rate. In formal terms,
it means that the forward rate and the current rate
differential must be equal to the expected spot rate and
the current spot rate differential. Thus:
Forward and current spot rate differential = Expected and
current spot rate differential

f F / D E ( sF / D )

sF / D sF / D
 International Fisher Effect
10

 In formal terms, the international Fisher effect

states that the nominal interest rate differential
must equal to the expected inflation rate
differential in two countries. Thus:
Nominal interest rate differential = Expected
inflation rate differential

(1  rF ) E (1  iF )

(1  rD ) E (1  iD )
 Foreign Exchange Risk
11

 Foreign exchange risk is the risk that the domestic

currency value of cash flows, denominated in foreign
currency, may change because of the variation in the
foreign exchange rate. There would not be any foreign
exchange risk if the exchange rates were fixed.

 We can distinguish between three types of foreign

exchange exposure:
 Transaction exposure
 Economic exposure
 Translation exposure
 Foreign Exchange Risk
12

 Transaction exposure involves the possible exchange loss or

gain on existing foreign currency-denominated transactions.

 Economic exposure refers to the change in the value of the

firm caused by the unexpected changes in the exchange rate. It
is also referred to as operating exposure or the long-term cash
flow exposure.

 A firm is exposed to translation loss if it uses current exchange

rate to translate its assets and liabilities. There are four
methods in use in translating assets and liabilities:
 Current/non-current method
 Monetary/non-monetary method
 Temporal method
 Current rate method
 Hedging Foreign Exchange Risk
13

 Forward contract
 Foreign currency option
 Money market operations

 The hedging techniques of foreign currency option and

money operations may not be available to companies in
many countries, particularly developing countries.
However, a large majority of companies can cover their
foreign exchange exposure through forward contracts.
 Hedging Foreign Exchange Risk
14

 Cost of forward contract is the difference between the

forward rate and the expected spot rate (not the current
spot rate) at the time cash flows are paid or received.
 Foreign Currency Option
15

 The foreign currency option is the right (not an

obligation) to buy or sell a currency at an agreed
exchange rate (exercise price) on or before an
agreed maturity period.
 The right to buy is called a call option and right to
sell a put option.
 A foreign currency option holder will exercise his
right only if it is advantageous to do so.
 Cost of put option
16
 Hedging Foreign Exchange Risk
17

 Another hedging technique is the money market

operations. Suppose, Air India can borrow FF 1,000
million now, convert them into rupees at the current
exchange rate and invest in the money market in India for
six months. If interest rate parity holds, the difference in
the forward rate and the spot rate is the reflection of the
differences in the interest rates in two countries. Thus, Air
India will be able to hedge against the change in the
exchange rate.
 INTERNATIONAL CAPITAL
INVESTMENT
18 ANALYSIS
 The basic principles applicable to an international
investment decision are similar to a domestic investment
decision.
 The incremental cash flow of the investment should be
discounted at an opportunity cost of capital appropriate to
the risk of the investment. The investment should be
accepted if the net present value is positive.
 One factor that distinguishes the international investment
decisions from the domestic investment decisions is that
cash flows are earned in foreign currency. This fact should
be considered while estimating the incremental cash flows.
 INTERNATIONAL CAPITAL
INVESTMENT
ANALYSIS
19

 Beta of a foreign investment can be calculated by

regressing the project’s return to a benchmark
market index.
 In fully integrated international financial
markets, both the firms and the individual
investors are free to invest anywhere in the world.
In this case, the project’s cost of capital does not
depend on any country. Investors could diversify
internationally and obtain the international
diversification benefits themselves. In this case,
beta is calculated relative the world market
index.
 Cont…
20

 Taiwanese Dollar Cost of Capital

 Formula for converting the Taiwanese dollar

cost of capital to the Thai baht cost of capital:
 Investment Evaluation: Parent
21
vs. Project
 Restrictionson Remittances
 Differences in Taxes
 Cash Flows to Parent
 POLITICAL RISK OF FOREIGN
INVESTMENTS
22

 There are two ways in which a firm can handle the

political risks in the investment evaluation.

 The firm may increase the cost of capital (discount rate) to

allow for the political risks
or
 Adjust the investment’s cash flows to account for political
risk.
 FINANCING
INTERNATIONAL
23
OPERATIONS
 Eurocurrency Loans
 Eurobonds and Foreign Bonds
 Depository Receipts
 Cost and Risk of International
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Financing
A firm may be capable of raising funds below
market rate due to government subsidies, tax
asymmetries government regulations.

 Borrowing in local currency to finance a foreign

investment can expose a company to foreign
exchange risks.