CHAPTER 34

INTERNATIONAL FINANCIAL MANAGEMENT

Q.1.
A.1 .

Q.2.
A.2.

Q.3.
A.3.

How does the financial management of an international firm differ from that of a
domestic firm?
International or multinational firms operate in more than one country and their
operations involve multiple foreign currencies. Their operations are influenced by
politics and the laws of the countries where they operate. Thus, they face higher
degree of risk as compared to domestic firms. A matter of great concern for the
international firms is to analyse the implications of the changes in interest rates,
inflation rates and exchange rates on their decisions and minimize the foreign
exchange risk.
What is a foreign exchange market? Who are the participants in a foreign
exchange market? What are their motivations?
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. Foreign exchange
(Forex) market is a world-wide market of an informal network of telephone, telex,
satellite, facsimile, and computer communications between the forex market
participants which include banks, foreign exchange dealers, arbitrageurs, and
speculators.
The foreign market operators are guided by different motives when they deal
in the foreign exchange market:
Arbitrageurs seek to earn risk-less profits by taking advantage of
differences in exchange rates among countries
Traders operate in the foreign exchange market because exporters receive
foreign currencies which they have to convert into local currencies, and
importers make payments in foreign currencies which they purchase by
exchanging the local currency.
Multinational firms operate in the foreign exchange market as hedgers to
protect themselves against the risk of fluctuations in the foreign exchange
rates.
Speculators are guided purely by the profit motive.
What is a spot exchange rate? How is it different from a forward rate? How will
you calculate forward premium or discount?
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.
The forward exchange rate is the rate that is currently paid for the delivery of a
currency at some future date. In terms of the volume of currency transactions, the
spot exchange market is much larger than the forward exchange market.
The forward rate may be at a premium or at a discount. Forward rate
premium or discount may be shown as an annualized percentage deviation from

the spot rate. For example, if forward dollars are more expensive than spot
dollars, the dollar is said to be trading at a premium relative to the Indian rupee.
For a direct quote, the annualized forward discount or premium can be
calculated as follows:
Spot rate - Forward rate 360
Forward premium (discount) =
Days
Spot rate

For an indirect quote, the forward premium or discount can be calculated

as follows:
Forward rate - Spot rate 360
Forward premium or discount =
Days
Spot rate

Forward contracts are tailor-made according to the firms needs. Two

parties to a forward contract can negotiate the terms in accordance with the
currency, amount, premium/discount or any other issue.
Q.4.

A.4.

You know the exchange rates of two countries. A third countrys exchange rate is
quoted against only the first of these countries. How can you determine the
exchange for this third country against the second country? Illustrate your answer.
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.
Currencies of many countries are not freely traded in the forex market. Therefore,
all currencies are not quoted against each other. Most currencies are, however,
quoted against the US dollar. The cross rates of currencies that are not quoted
against each other can be quoted in terms of the US dollar.
Given the exchange rates of two currencies, we can find the exchange rate
for the third currency. For example, the US dollarThai baht exchange rate is:
US$0.02339/baht and the US dollarIndian rupee exchange rate is:
US$0.02538/INR. Suppose that INR is not quoted against Thai baht. What is the
baht/INR exchange rate? One Indian rupee costs US$0.02538 while one baht
costs US $0.02339. Thus one Indian rupee should cost: 0.02539/0.02339 =
baht1.085. That is:
US$0.02538 US$0.02339 US$0.02538 Baht Baht1.085

=
INR
Baht
US$0.02339 INR
INR

Q.5.
A.5.

Name the four international parity conditions. Explain each one briefly.
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).

Q.6.
A6

What is interest rate parity? How does it work? Give an example to illustrate your
answer.
Interest rate parity characterizes the relationship between interest rates and

exchange rates of two countries. 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

(1 + rF ) f F / D
=
(1 + rD ) s F / D
where rF is interest rate of country F (say, the foreign country), rD is
interest rate of country D (say, domestic country), sF/D is the spot exchange rate
between the countries F and D and fF/D is the forward rate between the countries F
and D.
Suppose that the interest rate on a one-year bond (rupee-denominated) in
India is 14 percent while a similar bond (franc-denominated) in France pays 9
percent interest. The spot rate for French franc is FF 0.1522/INR and the 1-year
forward rate is FF0.1455/INR. If you have a choice of investment, which one
should you choose? You may notice that INR is trading at a forward discount.
(Alternatively, FF is trading at a forward premium relative to INR). Let us assume
that you have FF 1,000. If you invest FF 1,000 in France, at the end of one year,
you will receive: FF 1,000 1.09 = FF 1,090.
Alternatively, you can exchange FF 1,000 for the Indian rupees at the spot
rate; you will receive: FF 1,000/0.1522 = INR 6,570.30. You can invest INR
6,570.30 at 14 percent for one year. At maturity, you will receive: INR 6,570.30
1.14 = INR 7,490.14. You can sell the Indian rupees forward and immediately
receive French franc: INR 7,490.14 0.1455 = FF 1,090. Both investments are of
equal value. What you gain on the interest rate differential, you lose on the
exchange rate differential. In other words, there is a parity between the interest
rates and exchange rates, or simply interest rate parity. Thus:
1.14 0.1522
=
= 1.046
1.09 0.1455
Q.7.
A.7.

What is the Fisher effect? How is this principle extended to international finance?
We know that the nominal interest rate comprises a real interest rate and an
expected rate of inflation. The nominal rate of interest adjusts when the inflation
rate is expected to change. The nominal interest rate will be higher when a higher
inflation rate is expected and it will be lower when a lower inflation rate is
expected. This is referred to as the Fisher effect. It is formally expressed as
follows:

(1 + nominal interest rate) = (1 + real interest rate) (1 + inflation rate)

(1 + rn ) = (1 + rr ) (1 + i )
rn = rr + i + rr i

where rn is nominal rate of interest, rr is real rate on interest, and i is the

inflation rate.
If the international capital markets are perfect, then the equivalent risk
investments in two countries should offer the same expected real rate of return.
This is ensured by arbitrage. If the expected real rate of return is higher in one
country than in another, capital would flow from the second to the first country,
and investors will have opportunities to make riskless arbitrage profit. The
arbitrage activity will persist until equilibrium is established in the expected real
returns in the two countries. If the real rates of return are the same in two
countries, then, as per the Fisher effect, the nominal rates of interest in the two
countries will adjust exactly for the change in the inflation rates. 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 + i F )
=
(1 + rD ) E(1 + i D )
Q.8.
A.8.

Why should forward rate be the possible forecast of an expected future spot rate?
Suppose you are an exporter who is expecting to receive the US dollars in the
future, you have two choices. You can either wait until you receive your dollars or
then convert them into rupees. You are exposed to the risk of drop in the value of
dollar in the future. The second alternative is that you fix the price of the dollar
today and sell the US dollars forward. You are thus able to avoid risk of a
possible fall in the value of dollar. Suppose you happen to be an importer who is
required to make payment in the US dollars in the future. You will do the
opposite. You will buy the US dollars forward to avoid the risk of a possible
appreciation in the value of dollar in the future. If both the exporters and the
importers are in large numbers, the forward rate of US dollar relative to the Indian
rupee will be very close to the expected future spot rate. This is the expectation
theory of exchange rates.

Q.9.

What is the law of one price? How is it applied to international finance? Give an
example.
In an efficient forex market, comprising a large number of traders having access
to information without much cost, the arbitrage activity will ensure that the
disparities in the exchange rates are eliminated. It will also ensure that the
exchange-adjusted prices of similar goods and financial assets will be equal in all
the countries. This economic behaviour is referred to as the law of one price.

A.9.

Q.10. Explain with the help of an example how the international Fisher effect reflects

interest parity, purchasing power parity and the expectation theory of forward
rates.
A.10. Suppose the one-year interest rate is 5 percent on Swedish krona and the expected
inflation rate is 2 percent. The expected inflation rate on French franc is 6 percent.
The current spot exchange rate is FF1.063/SK (which is equal to FF1 =
SK0.9407). How much is the spot rate expected in one year? What will be the
one-year forward rate?
According to the international Fisher effect, the interest rate differential
must be equal to the inflation rate differential, and the interest rate differential
provides a forecast of the expected future spot rate. If the expectation theory of
exchange rate holds, then the forward rate should be equal to the expected future
spot rate. Thus:
1 + rF 1.06 E (s F / D ) f F / D
=
=
=
1.05 1.02
1.063 1.063

1.091 1.06 1.1047 1.1047

=
=
=
1.05 1.02 1.063
1.063
The interest rate on French franc is 9.1 percent; the expected future spot
rate and the forward rate are FF1.1047/SK (SK0.9052/FF).
Q.11. What is foreign exchange risk? What are the implications when foreign exchange
exposure is not covered or covered partially?
A.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. Some companies do not cover their foreign exchange
exposure or have a policy of partially covering their exposure. This policy suffers
from subjectivism as there is no sound method of deciding how much to cover
and how much to keep uncovered. The firms risk remains unlimited in the
partially covered exposure. In fact, keeping the foreign exchange exposure totally
or partially uncovered is tantamount to speculation.
Q.12. What is a forward cover? How does it provide a hedge against the foreign
exchange risk?
A.12. Companies can take a full forward cover against its foreign exchange exposure
and entirely hedge its risk. It can contract with a bank to buy foreign currency in
forward at an agreed exchange rate. This means that irrespective of the actual
exchange rate at the end of six months, its cost will remain same. The advantage
of this approach is that a companys management can concentrate on its
operations rather than worrying about the foreign exchange loss (or gain). Most
international companies have the policy of covering hundred percent of their
foreign exchange risk.
Q13.

Explain the foreign exchange option as a hedging technique. What are its pros and
cons?

A.13. 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. Except for the cost of option premium, the foreign
currency option provides a unique hedging alternative; you can avoid the loss by
exercising your option and gain from the favourable change in the exchange rate
by not exercising the option.
Q.14. How do money market operations provide hedging against the foreign exchange
risk?
A.14. Another hedging technique is the money market operations. A company can
borrow foreign currency 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, the company will be able
to hedge against the change in the exchange rate. The problem with the money
market alternative is that all markets are not open and all currencies are not fully
convertible. The Indian rupee is not fully convertible and there are restrictions on
the free flow of funds outside the country.
Q.15. How do international capital investment decisions differ from domestic capital
investment decisions? Explain the methods of evaluating international investment
decisions.
A.15. 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. The
cash flows can be estimated either in the domestic currency or in the foreign
currency. The financial managers should forecast the foreign exchange rates
assuming the parity conditions.
The opportunity costs should be appropriately modified, reflecting the
interest rate of the country in whose currency cash flows are estimated. A firm,
which is deciding to make investment in another country, must vouch for the
political risk in the host country. A firms exposure to political risk depends on
the host countrys political system, its economic conditions and the governments
policies and actions towards foreign direct investment (FDI) that affect the firms
investment cash flows.
Q.16. What are the various alternatives available to a firm to finance its international
investments? Explain two major methods of financing international operations.
A.16. Financial markets help to shift funds from the savers (lenders) to the investors
(borrowers) in exchange for a return. They allocate funds among the potential
users on the basis of the risk-return trade-off. International financial markets
transfer funds across countries. The government regulations in many countries do
not allow foreigners to access funds from those domestic financial markets.
The most important sources of international finance are: Eurocurrency

loans, Eurobonds, and American or Global Depository Receipts (ADRs or

GDRs).
Q.17. What is Eurocurrency market? How do Eurocurrency loans differ from
Eurobonds?
A.17. Most international firms can raise funds from the Eurocurrency markets.
Eurocurrency is any freely convertible currency deposited in banks outside the
country of its origin. Depositors put their savings in banks for short periods. Thus
they hold short-term claims on banks. Banks that make Eurocurrency loans to
international companies for a long period of time use these deposits. Thus the
short-term deposits are transformed into long-term claims on borrowers. Banks
act as intermediaries between the depositors and the borrowers. A borrower can
borrow in multiple currencies from the Eurocurrency market and may choose to
make payment of interest and principal in one or more currencies. The
Eurocurrency market is a very large market.
Eurobonds are bonds sold outside the country in whose currency they are
denominated. They are issued directly by borrowers to investors. For example, an
Indian company may issue US dollar-denominated bonds to investors in
Switzerland. Eurobonds may be issued in different currencies. They are known by
the currency in which they are denominated.
Q.18. How does the depository receipts methods of raising funds operate? What is an
American Depository Receipt? How is it different from a Global Depository
Receipt?
A.18. An indirect method of raising equity capital from foreign markets is to issue
depository receipts. A depository receipt represents number of foreign shares that
are deposited in a bank in the foreign country.
American Depository Receipts (ADRs) - A company issues its shares to a
reputed international financial institution in the USA that acts as a depository or
the transfer agent. The depository bundles a specified number of shares as a
depository receipt and issues them to investors in the USA. ADRs can be listed
and traded on the USA stock exchanges. The depository receives dividends from
the issuing Indian firm and then pays it to the depository receipt holders in the
USA. ADRs are denominated in US dollars and ADR investors receive dollar
equivalent dividends.
The Indian firms can also issue Global Depository Receipts (GDRs) in
many other countries. For example, GDRs allow an Indian firm (or any other
foreign firm) to raise funds from the UK, and list and trade GDRs on the London
Stock Exchange. A number of foreign countries also list their GDRs on the
Luxembourg Stock Exchange. Reliance and Grasim were the first companies to
issue GDRs in May and November 1992, respectively.