INTERNATIONAL FINANCIAL

MANAGEMENT
CHAPTER 34
LEARNING OBJECTIVES
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
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THE FOREIGN EXCHANGE 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
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Foreign Exchange Rates
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.
Across 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:
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$ 0.62 3.65
$ 0.17
US FF FF
DM US DM
=
Foreign Exchange Rates
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:
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Spot rate Forward rate 360
Forward premium (discount)
Spot rate Days
(
=
(

INTERNATIONAL PARITY RELATIONSHIPS
There are the following four international parity
relationships:
1. Interest rate parity (IRP)
2. Purchasing power parity (PPP)
3. Forward rates and future spot rates parity
4. International Fisher effect (IFE)
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Interest Rate Parity
It states 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
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/
/
(1 )
(1 )
F F D
D F D
r f
r s
+
=
+
Purchasing Power Parity
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
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/
/
(1 ) ( )
(1 )
F F D
D F D
i E s
i s
+
=
+
Expectation Theory of Forward Rates
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
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/ /
/ /
( )
F D F D
F D F D
f E s
s s
=
International Fisher Effect
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
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(1 ) (1 )
(1 ) (1 )
F F
D D
r E i
r E i
+ +
=
+ +
Foreign Exchange Risk
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:
1. Transaction exposure
2. Economic exposure
3. Translation exposure
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Foreign Exchange Risk
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:
1. Current/non-current method
2. Monetary/non-monetarymethod
3. Temporal method
4. Current ratemethod
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Hedging Foreign Exchange Risk
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.
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Hedging Foreign Exchange Risk
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.
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Foreign Currency Option
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.
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Cost of put option
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Hedging Foreign Exchange Risk
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.
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INTERNATIONAL CAPITAL INVESTMENT
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.
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Beta of a foreign investment can be calculated by
regressing the projects 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 projects 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.
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INTERNATIONAL CAPITAL INVESTMENT
ANALYSIS
Cont
Taiwanese Dollar Cost of Capital
Formula for converting the Taiwanese dollar
cost of capital to the Thai baht cost of capital:
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Investment Evaluation: Parent vs. Project
Restrictions on Remittances
Differences in Taxes
Cash Flows to Parent
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POLITICAL RISK OF FOREIGN INVESTMENTS
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 investments cash flows to account for political
risk.
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FINANCING INTERNATIONAL OPERATIONS
Eurocurrency Loans
Eurobonds and Foreign Bonds
Depository Receipts
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Cost and Risk of International 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.
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