International Finance Issues and Scope
International finance deals with the management of international financial flows, institutions, and foreign exchange rate between the two currencies. Functions of International Finance: Investment DecisionsInvestment decisions deals with the investing efficiently in overseas markets.
Finance decisionsFinance decisions deals with the raising of finance from international markets.
International Monetary System
The international monetary system refers to the policies, institutions, practices, regulations and mechanism that determines the rate at which one currency is exchanged for another.
The International Monetary System Consists
Policies related to the foreign exchange rate Institutions which monitor the exchange rate Practices regarding the management of forex rate Regulation regarding the management of forex rate Mechanism of the management of the forex rate
History of International Monetary System
Classical gold Standard
Under the gold standard, the currency which was in circulation consist or represents certain amount of gold. It was the oldest system which was in operation till the beginning of the 1st world war (1931). Under this system, the actual currency in circulation consists of coins with a fixed gold content.
Determination of Exchange Rate under Gold Standard
Exchange rate determination depends upon, currencies consist how much gold. Suppose, a pound sterling is worth 0.05 ounces of gold in the UK, and dollar is worth equal to 0.00125 ounces of gold in the US. Then the exchange rate between pound sterling and dollar would be 4.00dollar equal to 1 sterling pound.
International Monetary System
The Bretton Wood System (1946-1971)
To come up the depressed economy after world war 2nd, the US and UK and other countries agreed to overhaul the world monetary system to accelerate the international trade. The outcome was so called Bretton Wood System which become the cause of establishing International Monetary Fund (IMF) and World Bank in 1946.
The Bretton Wood System«cont
The exchange rate regime that was put in place can be characterized as the Gold Exchange Standard continued till 1971. Under this system the main mechanism of exchange rate was:
The US govt. undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce. Other member of IMF agrees to fix the exchange rate of their currencies against dollar with the variation within 1% on either side of the central parity being permissible.
International Financial Institutions
Under the Bretton Wood System two major financial institutions were established in 1946.
± International Monetary Fund ± International Bank for Reconstruction and Development (World Bank)
IMF
IMF was established to promote the financial stability among the member countries. The currency of the IMF is SDR (Special Drawing Rights). It is a currency basket whose value is the weighted average of the currencies of five countries (Germany, France, Japan, England, USA) The main roles of IMF are:
± To monitor the exchange rate policies of the member countries. ± To advise the developing countries about their monetary stability. ± To act as the lender of last resort-It means if member countries fails to avail financial help from any where than IMF would provide the financial help on concessional basis. ± To provide financial help to recover the balance of payment deficit.
World Bank
World Bank provide the financial assistance to the member countries for development purposes. To provide the long term loan to developing countries. IDA (International Development Association) which is known as soft window of loan of world bank provide long term loan to developing countries at highly subsidized rates. To provide financial assistance for Infrastructure projects.
Role of Bank for International Settlements
Role of BIS:
? Bank for International Settlements acts as the central bank for the industrial countries central banks. ? BIS helps central banks to manage and invest their foreign exchange reserves. ? BIS also coordinates with IMF on behalf of the member countries.
Post Bretton Wood System-Alternative Foreign Exchange Rate System
Foreign exchange rate system deals with how foreign exchange rate between two currencies is determined.
Fixed Exchange Rate system
Floating Exchange rate system Foreign Exchange rate system Managed Float system
Mixed Exchange rate system
Fixed Exchange rate system
Fixed exchange rate system is that exchange rate system where exchange rate is directly regulated by central bank, and it is determined accordingly. Under fixed exchange rate system, demand and supply forces have no role in determine the exchange rate.
$/Re S-forex
$/Re
D-forex
Reserve of Forex
Floating Exchange rate system
Floating exchange rate system is that exchange rate system where exchange rate is directly determined by demand and supply forces.
Demand for Foreign currency1.Importers 2. Gifts to abroad 3. Remittance to abroad 4.Financial Assistance to abroad. 5. Investment in foreign currency denominated assets.
$/Re
S-forex
$/Re D-forex
Supply for foreign currency? Exporters. 2. Gifts to home country. 3. Remittance to home country. 4. Financial assistance to home country. 5. Investment in home country .
Reserve of Forex
Managed Float Exchange Rate System
Managed float exchange rate system is that exchange rate system wherein the exchange rate is deliberately determined or fixed. Generally it is of two typesCrawling Peg exchange rate systemTarget Zone exchange rate system-
Crawling Peg Exchange Rate System
Crawling peg exchange rate system is also called managed float exchange rate system. It is that exchange rate system where foreign exchange is directly determined by central bank of the country. But in this exchange rate system, exchange rate is frequently adjusted depending upon the market requirements.
$/Re
$/Re
Reserve of Forex
Targeted Zone Exchange Rate System
In targeted Zone Exchange Rate System, Exchange Rate is kept at desired level by adjusting the all economic and commercial policies.
$/Re 52/1$ S-forex
45/1$ D-forex
Reserve of Forex
Mixed Foreign Exchange
Mixed exchange rate system is combination of fixed exchange rate system and floating exchange rate system. Under this system imports and exports of some items are subject of fixed exchange rate and imports and exports of some items are subject of floating exchange rate.
For exampleIn India the imports and exports of current a/c items are subject of floating rate. Importers and exporters are free to purchase and sell the foreign currency from open market. The imports and exports of capital a/c items are subject of fixed exchange rate. Importers and exporters have to purchase and sell the foreign currency at govt. determined exchange rate.
European Union and Monetary System
The European Monetary System began operating in 1979. Its objective was to foster monetary stability in the European Union. European Union consists 25 member countries. As of January 1999, common currency called Euro introduced in 11 courtiers for the purpose of commercial transactions and to accelerate the international trade among the member countries. Of late by June 2002, one more country currency replaced with Euro. The 12 countries are-Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, and Spain.
Impact of Single Currency on EU
1.Impact on European Monetary Policy
The euro allows for a single money supply throughout much of Europe, rather than a separate money supply for each member countries. The common currency promoted the political and economic ties among the member countries. The introduction of euro calls establishment of European Central Bank in Frankfurt and is responsible for setting monetary policy for all member countries.
Impact of Single Currency on EU«cont.
2. Impact on European Business
Adoption of common currency eliminated the currency movements among European countries, and also encourages more long term business arrangements between companies of two countries. Trade flows between member countries have increased because exporters and importers can conduct trade without having concern about exchange rate fluctuations.
Impact of Single Currency on EU«cont.
3. Impact on Financial Movements
A single euro forces the interest rate on govt. securities identical among the member countries. Any mismatch in interest rate foster the fund movements from one country to another country. Stock prices in member countries are also comparable because they are denominated in the same currency.
Impact of Single Currency on EU«cont
4. Impact on Exchange Rate Risk
Adoption of common currency is the advantage of elimination of foreign exchange rate risk. Besides it, the foreign exchange transactions cost have also eliminated.
Foreign Exchange Market
Foreign exchange market is that market where foreign currencies are traded at spot price or future price. Participants in Foreign Exchange Market-
Participants in Foreign Exchange Market1. Foreign Exchange Brokers- Foreign Exchange brokers are those entities which are ready to buy and sell the foreign currency. 2. Arbitrageurs- Arbitrageurs are those entities which take advantage of foreign exchange rate differential in two markets. USA Forex Market-For example in USA lets assume-Re.48/ $1 and in India Forex Market-Re.50/$1then arbitrageurs will start to purchase dollar in U.S stock market and sell it in Indian forex market. 3. Speculators- Speculators are those who take advantage of speculation in Forex Market. 4. Traders- These are entities which are in the business of export and import. 5. Hedgers- mostly multinational firms, engage in forward contracts to protect the value of outstanding contracts.
Transactions in Fx Market
All the transactions in foreign exchange market either take place at spot rate which is called spot market or forward rate which is called forward foreign exchange market.
Spot Foreign Exchange Market Foreign Exchange Market Forward Foreign Exchange Market
Transactions in Spot Market
Spot foreign exchange market is that market where currency is delivered at prevailing foreign exchange rate.
Spot Quotations in Foreign Exchange Market
Direct QuotationsIn foreign exchange market direct quotations exist when value of one unit of foreign currency is expressed in certain units of domestic currency. For example Re. 50/1$
Indirect QuotationsIn foreign exchange market indirect quotations exist when value of one unit of domestic currency is expressed in certain units of foreign currency. For example $0.02/Re 1
Transactions in Forward foreign exchange market
Forward foreign exchange market is that market where currency is delivered at some future date at an agreed price.
Forward Quotations
Forward quotations refers the way in which the value of foreign currency is expressed in some future date.
Forward Premium
When dealing with foreign exchange (FX), forward premium is a situation where the futures exchange rate, with respect to the domestic currency, is trading at a higher spot exchange rate. In other words forward rate is higher than the spot rate.
Forward Pr emium ! 360 Forward Rate Spot Rate v Spot Rate Forward Contract No. of days
Suppose spot Yen on Dec 3, 2001 sold at $0.008058, whereas 180 days forward Yen were priced at $0.008135. It means Yen is quoted 77 point premium. The annualized forward premium is:
Forward Pr emium ! 0.008135 0.008058 360 v ! 0.0191 or 1.91% 0.008976 180
Forward Discount
When dealing with foreign exchange (FX), forward discount is a situation where the futures exchange rate, with respect to the domestic currency, is trading at a lower spot exchange rate.
Forward Discount ! Forward Rate Spot Rate 360 v Spot Rate Forward Contract No. of days
Suppose the British pound was quoted $1.4248 while the 90 days forward pound was quoted at $1.4179. It means the pound is quoted 69 point discount. The annualized discount is:
Forward Discount ! 1.4179 1.4248 360 v ! 0.0194 or 1.94% 1.4248 90
Bid, Ask and Spread
Bid is that quotation at which foreign currency is purchased. Ask is that quotation at which currency is sold. Suppose pound is quoted at $1.4419-28. It means that banks are ready to purchase pound at $1.4419 and ready to sell at $1.4428. Spread is the difference between the bid price and ask price. For example if ask price for pound is $1.4428 and Bid price is $1.4419, then the spread will be:
Percentage Spread ! Ask Pr ice Bid Pr ice Ask Pr ice
1.4428 1.4419 v 100 ! 0.062% 1.4428
Percentage Spread !
Calculation of Forward rate from spot rates
What will be 30days and 60days forward rates ? Spot rate 30days 60 days ($/Bp): 2.20-30 10-20 30-20 Ans. 30 days forward rates will be: ($/BP): 2.30/2.50 60 days forward rates will be: ($/BP): 1.90/2.10
Notes: if exchange rates are expressed in such a manner, it is also called swap rates or outright rates. If swap rates are in increasing order just like in the case of 30 days. Then then points are added in spot bid and ask rate respectively. On the other hand if swap rates are in decreasing order, just like in the case of 60 days, then swap points are deducted from spot rates respectively.
Cross Rates with zero transaction cost
Cross Rates refers when exchange rate between two currencies is determined with the help of third currency with which the two currencies have exchange rate.
If $0.90/ ¼, then ¼1.11/ 1$, in the same way if $0.60/SFr, then SFr1.66/1$ The exchange rate between Euro and Swiss Franc will be-¼1.11=SFr1.66 or SFr1.49/1$
Cross Rates with positive transaction cost
Q. 1. spot rates are given as: $/euro: 1.3520/1.3550 $/BP: 2.0250/2.0285 What will be cross/synthetic rates ?
bid rate of Euro ! $ / euro : 1.3520 ! BP0.6665 / euro or euro1.50 / 1BP $ / BP : 2.0285 $ / euro : 1.3550 ! BP0.6691 / euro or euro1.49 / 1BP $ / BP : 2.0250
ask rate of Euro !
Cross/synthetic rates will be: BP/euro: BP0.6665/0.6691
Cross Rates with positive transaction cost
Q. 1. spot rates are given as: $/Bp: 1.4419-36 $/SFr: 0.6250-67 What will be cross/synthetic rates ?
bid rate of BP ! $ / BP : 1.4419 ! SFr 2.3007 / BP $ / SFr : 0.6267 $ / BP : 1.4436 ! SFr 2.3097 / BP $ / SFr : 0.6250
ask rate of BP !
Cross/synthetic rates will be: SFr/BP: 2.3007/2.3097
Currency Arbitrage
Currency arbitrage is a situation which involves purchasing a currency from a market where it is available at cheap rate, and selling the same currency where it is trading at higher rate. Type of arbitrage: 1 One point arbitrage: 2. Two point arbitrage 3. Three point arbitrage:
One point arbitrage
One point arbitrage implies purchasing currency at lower price and selling the same currency at the higher price in the market. If USD/BP :1.24/1.30 It means arbitrage can purchase 1 BP at 1.24 and sell at 1.30 for one dollar. The profit of arbitrageur from this arbitrage is USD0.06.
Indirect quotes and Two Point Arbitrage
Bank A is quoting in USA:
USD/BP: 1.4550/1.4560 It means bid rates of banks are $1.4550 for 1BP, and $1.4560 is ask rate for 1BP
Bank B is quoting in UK
USD/BP: 1.4538/1.4548 It means bid rates of banks are $1.4538 for 1BP, and $1.4548 is ask rate for 1BP Now arbitrate opportunities are there, arbitrageur will purchase 1BP from UK at $1.4548 and sell at $1.4550 in USA. Net profit will be (1.4550-1.4548)=$0.0002
Triangular Arbitrage
Suppose pound is bid at $1.5422 in New York and euro is offered at $0.9251in Frankfurt. At the same time London banks are offering pound at Euro1.6650.
$1.5422/1BP (New York) $0.9251/1Euro (Frankfurt) Euro1.6650/1BP (London) 1 2 3
Let¶s examine whether arbitrage opportunities exist or not:
As we known 1 and 3 are equal. $1.5422=Euro1.6650 or $0.9260/1Euro
But in Frankfurt the exchange rate between dollar and euro is $0.9251, it means arbitrage opportunities exists.
Triangular Arbitrage«cont
New York $1.5422/1BP
Sells Pound in New York at $1.5422/1Pound for $1,001,239.05 (649227.76*1.5422)
Arbitrager acquires $1million in New York
London Euro1.6650/1BP
Sells euro1,080964.22 in London at euro1.6650/1pound for Pound649227.76 (1080964.22*0.600)
Frankfurt $0.9251/1Euro
Sells $10,00,000 in Frankfurt at $0.9251/1euro for euro 1,080964.22 (10,00,000*1.080964)
Net Profit from Arbitrage=$1,001,239.05-10,00,000=$1239.05
Triangular Arbitrage with positive transaction cost
The bid and ask rates of different currencies are given in three different markets. Is there any arbitrage opportunities? JY/$:110.25/111.10 R/$:1.6520/1.6530 JY/R:68.30/69.50 There will be no arbitrage opportunities if the following condition is holding true:
1 * bid ( R / $) * bid ( JY / R) e 1 ask ( JY / $)
1 *1.6520 * 68.30 ! JY1.015 111.10
The calculated value 1.015 is more than 1, it means arbitrage opportunities are possible. If we start with JY 10,0000, than finally we will haveJY10,00,000*1.015=JY101500
Triangular Arbitrage with positive transaction cost
The bid and ask rates of different currencies are given in three different markets. Is there any arbitrage opportunities? Value of BP in USD:$1.60/$1.61 Value of Real in USD:$0.200/$0.24 Value of BP in Real: R8.10/R8.20 There will be no arbitrage opportunities if the following condition is holding true:
1 * bid ($ / R) * bid ( R / BP ) e 1 ask ($ / BP)
1 * 0.200 * 8.10 ! $1.0062 1.61
The calculated value 1.062 is more than 1, it means arbitrage opportunities are possible. If we start with $10,0000, than finally we will have$10,00,000*1.062=$1006200
Foreign Exchange Derivative Market
Foreign exchange derivative market is that market where such kind of financial instruments are traded which are used to hedge the foreign exchange risk. MNCs which have global business operation are getting their sales in multiple currencies. So large and unexpected fluctuations in exchange rate between domestic currency and host currency will expose the company to the foreign exchange risk. To the hedge the foreign exchange risk MNCs and other investors purchase derivative contracts.
Forward Market
A forward contract is a contract in which currency is delivered in future date at an agreed price.
Features 1. Non Standardized Contracts. 2. Traded at over the counter the market. 3. Fear of Default. 4. No involvement of third party. 5. Party known to each other very well.
Futures Contract
A future contract is contract in which seller agrees to make delivery of specified amount of currency at specified future date at specified exchange rate. A Future contract is stated in details. Under Future contract both the parties have to put a margin money to clearing house. In case of default the margin of the respective party is seized.
Features ±
1. Standardized Contract. 2. Between two parties who not necessarily known to each other. 3. No default, guarantee for performance by a clearing corporation or clearing house. 4. Margin placement to the clearing house.
Future Contracts
Future Contracts Commodity Future Financial Future
Futures on Stocks
Stock Index Futures
Foreign Ex. Futures
Interest rate Futures
Application of the Future Contracts
Hedging Hedging involves wherein exporters, importers and firms need foreign currency purchase future contract to avoid the unexpected fluctuations in the forex markets. Trading Future contracts are financial products which are used for trading purposes. Traders are purchasing and selling future contracts mearly for trading purpose.
Application of the Future Contracts«cont
Speculation Speculators take advantage of Forex market fluctuations by purchasing the currency futures. International Spreading
When there are expectations that two Forex will not covary in the same directions then International spreading like Straddle or Strangle can be created to utilize this situations.
Arbitrage Between two stock Exchanges
Arbitrager is a process of taking advantage of price differential of two Forex markets.
Options
Call Option on Currency
A call option is that agreement in which the writer or seller gives the right to purchase a specified amount of currency at specified exchange rate to the option buyer or investor. A call option is purchased to minimize the risk of hiking the price of underlying currency.
Call Options are purchased to hedge the upside risk.
Top to Bottom
Calculation of Profit/Loss of Investor on Call Option
Call Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.
60K 40K 20K 44 20K 40K 50K 60K 46 48 50 52 54 56
Spot Ex. Rate 44/$
Spot Ex rate
Gross Net Profit/Loss Profit/Loss -20000 -20000 -20000 -20000 20000 40000 60000 -20000 -20000 -20000 -20000 0 20000 40000
46/$ 48/$ 50/$ 52/$ 54/$ 56/$
Profit/Loss of Investor
Calculation of Profit/Loss of Writer on Call Option
Call Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.
Spot Ex. Rate 44/$ 46/$
44 46 48 50 52 54 56
60K 40K 20K 0 20K 40K 50K 60K
Gross Profit/Loss 20000 20000 20000 20000 -20000 -40000 -60000
Net Profit/Loss 20000 20000 20000 20000 0 -20000 -40000
48/$ 50/$ 52/$ 54/$
Spot Ex rate
Profit/Loss of Writer
56/$
Put Option
A put option is that agreement in which the writer gives the right to sell the specified amount of foreign currency at specified exchange rate to the option seller or writer. A put option is purchased to minimize the risk of declining the price of underlying currency. Put Options are purchased to hedge the downside side.
Put Option
Contract Size $10,000 Exercise Price 45/$ Option Premium Rs 4/$ Maturity Period 3 months
Bottom to Top
Calculation of Profit/Loss of Investor on Put Option
Contract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.
Spot Ex. Rate 46/$ 48/$
46 10K 20K 30K 40K 48 50 52 54 56 58
30K 20K 10K 0
Gross Net Profit/Loss Profit/Loss 60000 40000 20000 -20000 -20000 -20000 -20000 40000 20000 0 -20000 -20000 -20000 -20000
50/$ 52/$ 54/$ 56/$
Spot price
Profit/Loss of Investor
58/$
Calculation of Profit/Loss of writer on Put Option
Contract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.
Spot Ex. Rate
30K 20K 10K 46 10K 20K 30K 48 50 52 54 56 58
Gross Profit/Los s -60000 -40000 -20000 20000 20000 20000 20000
Net Profit/Los s -40000 -20000 0 20000 20000 20000 20000
46/$ 48/$ 50/$ 52/$ 54/$ 56/$
Spot price
Profit/Loss of Writer
58/$
Types of Options
American Call Options American Options Options European Call Options European Options European Put Options American option-American option can be exercised at any time with the maturity period. European option-European option can not be exercised before the maturity period. American Put Options
Financial Swaps
Financial swaps is a process in which two business organization change their financial obligation. Financial swaps are widely used by MNCs, Banks and Govts. Minimize the credit and currency risk. Financial swaps take place against a notional amount.
Measuring Exchange Rate Movements
? An exchange rate measures the value of one currency in units of another currency. ? When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate. ? On the days when some currencies appreciate while others depreciate against a particular currency, that currency is said to be ³mixed in trading.´
Measuring Exchange Rate Movements
? The percentage change (% (
in the value of a foreign currency is computed as
St ± St ± 1 St ± 1 where St denotes the spot rate at time t.
? A positive % ( represents appreciation of the foreign currency, while a negative % ( represents depreciation.
Determination of Exchange Rate
Exchange rate between two currencies is determined on the basis of demand and supply forces. It means where demand for foreign currency curve will intersect the supply curve of foreign currency, the exchange rate will be determined at that level.
Derivation of Demand curve for Foreign currency
The demand for foreign currency is inversely related to the exchange rate. At higher exchange rate, there will be less demand for foreign currency. At lower exchange rate, demand for foreign currency will be high. It can be shown in the diagram:
Exchange rate 40/$ 42/$
Df
X1 X2 Amount of Foreign Currency
Derivation of Supply curve for Foreign currency
The supply of foreign currency is positively related to the exchange rate. At higher exchange rate, there will be high supply of foreign currency. At lower exchange rate, supply of foreign currency will be low. It can be shown in the diagram:
Sf Exchange rate 40/$ 42/$
X1 X2 Amount of Foreign Currency
Demand and Supply in Determination of Foreign Exchange Rate
In competitive foreign exchange market, exchange rate will be determined at the level where demand and supply will be equal to each other.
Demand for Foreign currency$/Re $/Re D-forex 1.Importers 2. Gifts to abroad 3. Remittance to abroad 4.Financial Assistance to abroad. 5. Investment in foreign currency denominated assets.
S-forex
Supply for foreign currency? Exporters. 2. Gifts to home country. 3. Remittance to home country. 4. Financial assistance to home country. 5. Investment in home country .
Reserve of Forex
Factors affecting the Foreign Exchange Rate
There are number of factors which determines the exchange rate between two currencies. These are:
Inflation Terms of Trade, Amount of Trade Foreign Investment Service trade, Capital Inflows
Inflation
Inflation in the home Country
If there is inflation in the home country, it means more imports will be done. In order to pay for imports, people will create more demand for foreign currency. As a result, the demand curve for foreign currency will shift toward right. The exchage rate will increase. It is shown in the figure 1.
Inflation in the host country If there is inflation in the host country, it means more exports will be done. Higher exports will generate more export earnings, as result the supply of foreign currency in the domestic economy will increase. As a result, the supply curve for foreign currency will shift toward right. The exchage rate will come down. It is shown in the figure 2.
Sf1 Exchange rate 40/$ 42/$ Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Terms of Trade, amount of trade
Terms of trade in favour home Country
If terms of trade are in favour of home country, it means more exports will be done. Higher exports will generate more foreign currency. As a result, the supply curve of foreign currency will shift toward right and vice versa. It is shown in the figure 2.
Terms of trade in favour of host country If terms of trade are in favour of host country, it means more imports will be done. In order to pay for imports, more demand for foreign currency will be created. As a result, the demand curve of foreign currency will shift toward right and vice versa. It is shown in the figure 1.
Sf1 Exchange rate 40/$ 42/$
Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Foreign Investment
Higher foreign investment in the home country
Higher foreign investment in the home country will create more inflows of foreign currency in the home country. As a result the supply of foreign currency will increase. As a result, the supply curve of foreign currency will shift toward right and vice versa. It is shown in the figure 2.
Higher foreign investment in the host country
Higher investment in the host country will create more demand for foreign currency in the home country. As a result the demand for foreign currency will increase. As a result, the demand curve of foreign currency will shift toward right and vice versa. It is shown in the figure 1.
Sf1 Exchange rate 40/$ 42/$ Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Determination of Foreign Exchange Rate
There are number of factors which determines the exchange rate between two currencies. These are:
Demand and Supply conditions of a currency Central Bank Intervention Govt. controls on forex rates
Factors that Influence exchange Rates
Government Controls
? Governments may influence the equilibrium exchange rate by: ± imposing foreign exchange barriers, ± imposing foreign trade barriers, ± intervening in the foreign exchange market, and ± affecting macro variables such as inflation, interest rates, and income levels.
Intervention of Central Bank
The central bank of the country have dominate role in determining the exchange rate between domestic currency and foreign currency. If central bank wants to increase the exchange rate, then central bank will start to purchase the foreign currency with domestic currency. On the other hand if central bank wants to lower down the exchange rate then central bank starts to sell the foreign currency in exchange of domestic currency in the market. In fact central bank do the intervention in the market by two ways1. Sterilization Intervention 2. Unsterilized Intervention
Sterilization and Unsterilized Intervention
In fact, when central when central bank sells the domestic currency in exchange of foreign currency in order to regulate the value of the foreign currency. It leads rise in the supply of the money in the domestic market which results inflation in the economy. So when central bank doest not insult their domestic money supply from the foreign exchange transactions, this is called unsterilized intervention. On the other hand, when central bank insult their domestic money supply from the foreign exchange transactions, this is called sterilized intervention
Sterilization Intervention
In case of sterilized intervention when central bank sells domestic currency in exchange of foreign currency it leads inflation in the economy. To check this inflation central bank simultaneously starts to absorb this excess money supply from the market through open market operation. In open market operation central bank sells short term securities like Treasury bills in the market to absorb excess liquidity. So in sterilized intervention, central bank regulate the exchange rate but at the same time insulate the inflation from the exchange rate.
Theories of Exchange Rate Determination
There are two theories which empirical examines how the exchange rate between two currencies are determined. These theories are:
Purchasing power parity theory Interest rate parity theory
Purchasing power parity theory of Exchange Rate
The theory of purchasing power parity (PPP) explains movements in the exchange rate between two currencies by changes in the price levels of respective countries.
The exchange rate between two countries¶ currencies equals the ratio of the counties¶ price levels. It compares average prices across countries. It predicts a Re/dollar exchange rate of:
Re/ $ ! Pr ice( Ind ) / Pr ice(US )
Purchasing Power Parity
?Absolute PPP and Relative PPP Absolute PPP
? It states that exchange rates equal relative price levels.
For example if in USA a basket of goods can be purchased by one dollar, and the basket of same goods can be purchased in India by Rs 50/-, the exchange rate between rupee and dollar will be 50/1$. Likewise if Burger in USA cost USD2.43 and the same burger is of BP 1.90 in England then the exchange rate between USD and BP is
USD2.43/BP1.90=USD1.29/BP1
Purchasing power parity theory of Exchange Rate«cont.
Relative PPP
? It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.
et ! 1 Pf 1 Ph 1
Where et is forward rate, Ph is price level in the home country, Pf is the price level in the foriegn country.
Relative PPP «example
For example if inflation in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:
et !
1 0.05 1 ! 0.045 or 4.5% 1 0.10
It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BP So, the exchange rate between USD and BP will be USD1.53/BP.
Relative PPP «example
For example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:
et ! 1 0.05 1 ! 0.0194 or 1.94% 1 0.03
It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFr So, the exchange rate between USD and SFr will be USD0.760/SFr.
Relative PPP «example
For example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be: 3 month inflation in US will be = 5*3/12=1.25% 3 month inflation in Switzerland = 3*3/12=0.75%
et ! 1 0.0125 1 ! 0.0050 or 0.50% 1 0.0075
It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFr So, the 90 days forward rate will be USD 0.753/SFr.
Important slide
Real Exchange Rate
The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currencies. In other words real exchange rate is inflation adjusted exchange rate.
1 ih Where et is real exchange rate, eo is spot exchange rate, ih is inflation rate in home country, if is inflation in foreign country, t is time period. et ! 1 i f 1
Alternatively when some exchange rate is adjusted with some price index like WPI or CPI, then the real exchange rate will be:
et ! e0 ( f / h) Pf Ph
Where et is real exchange rate, eo is spot exchange rate, Ph is inflation rate in home country, Pf is inflation in foreign country, t is time period.
Calculating the Real exchange rate between USD and Japanese Yen
Between 1980 and 1995, the USD/JY moved from JY 226.63/USD 1 to JY93.96. During this 15 years, the consumer price index (CPI) in Japan rose from 91.0 to 119.2, and CPI in USA rose from 82.4 to 152.4. Q. 1. if PPP had held over the period, what would the USD/JY exchange rate in 1995?
Pf Ph 119.2 / 91.0) ! JY160.51 / USD1 (152.4 / 82.4)
et ! e0 ( f / h)
! ( 226 / 1)
Calculating the Real exchange rate between USD and Japanese Yen«cont
Q.2. What happened to the real value of the yen in terms of dollars during this time period?
Ph 119.2 / 91.0) ! (1 / 93.96) ! USD0.007538 / JY 1 Pf (152.4 / 82.4)
et ! e0 (h / f )
International Fisher Effect
International Fisher effect integrates the purchasing power parity theory and Fisher effect in explaining the behavior of exchange rate between two currencies. PPP states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels. On the other hand Fisher effect states that with no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries.
International Fisher Effect
The interest rates which are quoted for financial contracts are stated in nominal terms. According to fisher effect, the real interest rate must be adjusted to reflect the expected inflation. It states that nominal interest rate is made up of two components real required rate of return and inflation premium equal to the expected amount of inflation. The fisher equation is:
R=Required rate of return + Expected inflation R=a + i If required rate of return is 3% and inflation is 10%, then nominal interest rate must be 13%.
Fisher Effect«.cont
Fisher effect states that the real rate of return on financial contracts are equal across the countries that is: af=ah If expected real returns is higher in one currency than another than capital flow would flow from the second country to first country. In equilibrium then no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries.
Rh R f ! ih i f
If inflation rates in the USA and UK are 4% and 7% respectively, then Fisher effect states that nominal interest rate in UK should be 3% higher then USA.
.
Fisher Effect«.cont
In conclusion International fisher effect states that higher interest rate in the home country will lead depreciation in the value of the home country, on the other hand a lower interest rate in the home country will lead appreciation in the value of the home currency. This relationship can be shown in the following equation and diagram.
et !
1 I f 1 Ih
1
Fisher Effect«.cont
Appreciation/Depreciation of home currency
4 3 2 1 A
1% 2% 3%
Parity Line B
-5%
-4%
-3%
-2%
-1%
4%
5%
-1 C -2 -3 -4
Interest rate differential in favour of home country
Fisher Effect«.cont
At point A, interest rate differential is 1% in favour of home country, it will lead 1% market appreciation of the home currency. At point C interest rate differential is -2%, it means home interest rate is 2% more than the interest rate of foreign country. As a result the home currency will depreciate by 2%.
IFE«example
For example if interest rate in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:
et !
1 0.05 1 ! 0.045 or 4.5% 1 0.10
It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BP So, the exchange rate between USD and BP will be USD1.53/BP.
IFE«example
For example if interest rate in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:
et ! 1 0.05 1 ! 0.0194 or 1.94% 1 0.03
It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFr So, the exchange rate between USD and SFr will be USD0.760/SFr.
IFE«example
For example if interest in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be: 3 month interest in US will be = 5*3/12=1.25% 3 month interest in Switzerland = 3*3/12=0.75%
et ! 1 0.0125 1 ! 0.0050 or 0.50% 1 0.0075
It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFr So, the 90 days forward rate will be USD 0.753/SFr.
Interest Rate Parity Theory
According to IRP theory spot and forward rates are closely related to each other and it is the interest rate differential between the two currencies which creates the opportunities for arbitrage. In other words interest rate differential should be equal to the forward rate differential. Interest rate parity ensures that the return on a hedged (covered) foreign investment will just equal the domestic interest rate on investment of identical risk. When this condition holds the covered interest rate differential will be zero.
Interest Rate Parity Theory«.cont
The covered interest arbitrage relationship can be explained as follow: Let eo is current spot rate, et is forward rate, if rh and rf is prevailing interest rate in New York and London respectively, then one dollar invested today in NY will yield 1+rh at the year end. The same dollar invested in London will be worth (1+rf)et/eo. Now Funds will flow from New York to London, if following situation happens: e 1 rh (1 rf ) t e0 Now Funds will flow from London to NY, if following situation happens: et 1 rh " (1 r f ) e0
Covered Interest Arbitrage
The interest rate on pound is 12% in London, and 7% on USD in New York on comparable investment. The pound spot rate is $1.75 and the one year forward rate is $1.68.
1.68 1.75
1 0.12 (1 0.07)
1.12 1.02
It means funds will flow from New York to London.
Borrow USD10,00,000 in New York at an interest rate of 7%.This means at the year end arbitrager will have to repay USD10,70,000. Convert the USD 10,00,000 to pound at the spot rate $1.75 for pound 571428.57 (10,00,000/1.75). Invest pound 571428.57 at 12% for one year in London which will yield pound 640000 to arbitrageur after one year. Simultaneously sell pound 640000 one year forward contract at a rate of $1.68, which will yield USD10,75,200. Net profit=10,75,200-10,70,000=USD 5200.
IRP and Covered Interest Arbitrage
The interest rate on USD is 8% per annum in New York and 6% per annum on euro in London. The current spot rate is euro1.13110/USD1, and the 90 days forward rate is euro1.12556/USD1. Show the covered interest arbitrage regardless of currency choice of the investor?
Investor starts with $ 10,00,000 in New York. He will convert $10,00,000 to euro at euro1.13110/USD1 for euro11,13,100 (10,00,000*1.13110) in London. He will invest euro 11,13,100 at 1.5% for 90 days, yielding him euro 11,48,066.50. Simultaneously with euro investment, sell the euro 11,48,065.50 forward contract at rate of euro1.12556/USD1 for delivery in 90days, and receive $10,20,000 Net profit $10,00,000-$10,20,000=$20,000
Covered Interest Arbitrage with transaction cost
International Exposure
Foreign Exchange Risk refers to which a company is affected by changing in exchange rates. A large number of factors affects the exchange rate between home currency and host currency which in turn affect the market value of the company.
International Exposure
Translation Exposure or Accounting ExposureChanges in income statement items and the book value of balance sheet assets and liabilities that are caused by an exchange rate change.
Operating ExposureChanges in operating cash flows caused by an exchange rate change.
Transaction ExposureChanges in the value of outstanding foreign currency denominated contracts.
Operating and Transaction exposure combined together is also called economic exposure.
Currency Translation Method
Companies with international operations will have foreign currency denominated assets and liabilities, revenues and expenses. However, they have to assigned home currency values to all the foreign currency denominated assets and liabilities, revenues and expenses. In other words, financial statements of an MNCs subsidiary must be translated from host currency to home currency before consolidated with the parent co. financial statements.
Methods of Translation or Accounting Exposure
Methods of Translation or Accounting Exposure«cont
Current/Non Current Method? With this method, all the foreign subsidiary¶s current assets and liabilities are translated into home currency at the current exchange rate. Each non current assets and liabilities are translated into home currency at its historical exchange rate-that is at the rate when these assets/liabilities acquired. ? The income statement is translated at the average exchange rate of the period except for those revenues and expenses items associated with non current assets or liabilities.
Methods of Translation or Accounting Exposure«cont
Monetary/Non Monetary Method? This method differentiates between monetary assets and liabilities- that is those items that represents a claim to receive or an obligation to pay a fixed amount of foreign currency units-and non monetary or physical assets and liabilities. Monetary assets/liabilities are translated at the current rate and non monetary assets/liabilities for example inventory, fixed assets and long term investment are translated at historical rate. ? Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non monetary assets and liabilities.
Methods of Translation or Accounting Exposure«cont
Temporal Method? It is similar to monetary/non monetary method. The only difference is that monetary/non monetary method; inventory is translated at historical rate. Whereas in Temporal method inventory is translated at current rate if the inventory is shown on the balance sheet at market value.
Current Rate Method? All balance sheet items and income statement items are translated at the current rate.
After devaluation LC5/$1 LC LC4/$1 Monetary/ Nonmonetary Assets Cash Inventory Prepaid expenses Total current Assets Fixed Assets Accumulated depreciation Goodwill Total Assets Liabilities Current Liabilities Long term debt Deferred income tax Total Liabilities Capital Stock Retained earnings Total equity Total equity+Total liabilities Translation gain/loss 3400 3000 500 6900 1500 2600 4100 11000 850 750 125 1725 375 650 1025 2750 680 600 100 1380 375 865 1240 2620 215 680 600 100 1380 375 685 1060 2440 35 680 750 125 1555 375 500 875 2430 -150 680 600 100 1380 375 445 820 2200 -205 3600 1000 11000 900 250 2750 900 250 2620 900 250 2440 900 250 2430 720 200 2200 2600 3600 200 6400 650 900 50 1600 520 900 50 1470 520 720 50 1290 520 720 40 1280 520 720 40 1280 Temporal Current/ Noncurrent Current rates
How to manage Translation Exposure ?
1.Fund adjustment
Fund adjustment involves the altering the amounts or the currencies of the planned cash flows of parent or its subsidiaries to reduce the firm local currencies exposure. If an local currency depreciation/devaluation is expected, fund adjustment methods include pricing exports in hard currencies and imports in the local currencies, investing in hard currency securities and replacing the hard currency borrowings into local currency borrowings.
How to manage Translation Exposure ?...cont
2. Forward/Options Market Hedge? Micro Soft USA has the currency exposure of INR and Indian Companies have the exposure of US dollar. To hedge their situations Micro Soft USA would like to purchase a put/call option over INR to limit its downside/Upside risk. On the contrary, Indian Companies would like to purchase call/Put option over dollar to limit their upward/upside risk.
How to manage Translation Exposure ?...cont
3. Selecting Convenient Currency
Selecting less risky currencies for invoicing exports and imports and adjusting transfer prices are also the good techniques to reduce the translation exposure.
4. Exposure nettingThis techniques is based on cross hedging. It techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.
Statement of Financial Accounting Standards No 52 (FASB-52)
The current translation, Statement of Financial Accounting Standards No. 52 (FASB-52) was adopted in 1981. As per FASB-52, firms must use the current rate method to translate foreign currency denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items are recognized or at appropriate weighted average exchange rate for the period.
Statement of Financial Accounting Standards No 52 (FASB-52)
FASB-52 differentiates between functional currency and reporting currency. A functional currency is that one in which subsidies reports income and expenses. For example Pepsi India reporting its income and expenses in INR in India, so the functional currency is the INR. The reporting currency is the currency in which the parent co. prepares its financial statement. FASB-52 requires that the financial statement of a foreign unit first be stated in the functional currency using generally accepted accounting principles and then in reporting currency.
Managing Operating Exposure
Currency risk affects all facets of a company operations, it should not be the concern of financial manager alone. Operation manager should develop marketing and production strategy to minimize the impact of host currency risk.
Managing Operating Exposure«cont
Marketing Management of Exchange Risk
Marketing strategy calls designing the marketing strategy to minimizing the currency risk.
1.Market SelectionMNC should select that market whose currency is not so sensitive to global economic and non economic shocks.
2. Pricing StrategyCo should keep the price of its product less where the currency is very soft. On the other hand, co. should keep the price high very currency is hard.
Managing Operating Exposure«cont
3. Product StrategyCompanies often respond to exchange risk by altering their product strategy, which deals with such areas as new product introduction, product line decisions, and product innovation.
Managing Operating Exposure«cont
Production Management of Exchange Risk
MNC can manage the currency risk by working on product sourcing and plant location.
1.Input MixMNC can outsource the inputs from the countries where value of the currency is low and sell the final product to the countries where the value of the currency is high.
Managing Operating Exposure«cont
2.Shifting the Production among the PlantsMNCs can relocate their production among their plants in line with the changing dollar costs of production, increasing the production in a nation whose currency has devaluated and decreasing the production in the nation whose currency has been revaluated.
3. Plant locationShifting the plant to the countries where currency is hard.
Managing Operating Exposure«cont
Finance Strategy1. Company should purchase call option if company has payables. 2. Company should purchase put options if company has receivables.
Techniques to Manage the Transactions Exposure
If an MNC decides to hedge part or whole of all its transaction exposure, it may select from the following techniques:
1. 2. 3. 4. Futures hedge Forward hedge Money market hedge Currency Options
Future Hedge
Currency futures can be used by firms that desire to hedge transaction exposure. Purchasing currency future A firm which has to make some payments in the future date in foreign currency can purchase future contract on that currency from the future market. By purchasing the future contract on foreign currency, it locks in the amount of foreign currency needed to make the payment. Selling currency future A firm which is expected to receive payment in foreign currency is facing downside risk. Firm can sell future contract in the market over the currency which is expected to receive.
Forward Hedge
If the parent co. has the receivable than co. can take short position over the forward/future contract. On the other hand if the co. has payable than co. can take long position over the contract covering the underlying currency. Calculating the Real Cost of Hedge:
A forward hedge will be more costly than the no hedge can be estimated by calculating the real cost of hedging payables (RCH). The RCH measures the additional expenses beyond those incurred without hedging. RCH=NCH-NC
Expected value of RCH .P ! § Pi .RCH i
Where, NCH is nominal cost of hedging payables, NC is nominal cost of payables without hedging.
Forward Hedge«example
Durham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. What is the real cost of hedging is spot rate of BP is either at $1.38 or $1.42 after 90 days? Real cost of hedging when exchange rate $1.38: NCH = BP1,00,000x$1.40=$1,40,000 NC = BP1.00,000x$1.38=$1,38,000 RCH = $1,40,000-$1,38,000=$2000 Real cost of hedging when exchange rate $1.42: NCH = BP1,00,000x$1.40=$1,40,000 NC = BP1.00,000x$1.42=$1,42,000 RCH = $1,40,000-$1,42,000=-$2000 The real cost of hedging is more favorable, when real cost of hedging is negative.
Forward Hedge«example
Durham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. what will be the expected value of the real cost hedge if following spot rates exists in next 90 days ? Spot ex. Rates $1.38 1.32 1.43 1.36 1.38 1.40 1.42 1.45
Probability Spot rate 1.3 1.32 1.34 1.36 1.38 1.4 1.42 1.45 5% 10% 15% NCH.P $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 20% 20% NC.P $1,30,000 $1,32,000 $1,34,000 $1,36,000 $1,38,000 $1,40,000 $1,42,000 $1,42,000 15% 10% RCH.P $10,000 $8,000 $6,000 $4,000 $2,000 $0 ($2,000) ($5,000) 5% probability 5% 10% 15% 20% 20% 15% 10% 5%
Forward Hedge«example
The expected value of the real cost of hedging can be measured as follow:
Expected value of RCH .P ! § Pi .RCH i
E(RCH)= 0.05($10000)+0.10($8000)+0.15($6000)+0.20($4000)+0.20( 2000)+0.15(0)+0.10(-$2000)+0.05(-$5000) =$2,950
Money market Hedge
A money market hedge involves taking money market position to cover a future payables or receivables position. Money Market hedge on Payables: If a firm has excess cash, it can create a short term cash deposit in the foreign currency that will be need in the future.
Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The exchange rate between USD and NZD is USD0.65/NZD1. How much USD will be need to have NZ$1000000 after one month?
Money market Hedge
Amount need today to have NZD1000000=1000000/1+0.005=NZD995025 If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month.
lets assume Microsoft does not have excess cash. So it can borrow from bank and can create cash deposits in host county.
Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The interest rate in US is 8.4% annual (0.7% monthly). The exchange rate between USD and NZD is USD0.65/NZD1. Now much USD will be need to have NZ$1000000 after one month?
Money market Hedge
Amount need today to have NZD1000000=1000000/1+0.005=NZD995025 If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month. Microsoft can borrow this amount at 0.7% monthly interest rate today after one month will pay principal amount and interest= 646766x1.007=USD651293.
Money market Hedge
Money Market hedge on Receivables: If firm expects cash receivables in a foreign currency, it can hedge this position by borrowing the currency now and converting it to dollar. This receivables can be used to set off the loan.
Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. The exchange rate between USD and SD is SD0.80/USD1. how much USD Bakersfield can have to set off the loan?
Money market Hedge
SD which can be borrowed SD400000=400000/1+0.02=SD392157 Bakersfield will borrow SD392157 today will covert it into USD. If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25 to set off some loan.
lets assume Microsoft does not have to set off any loan. Then Bakersfield can invest this amount in US securities.
Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. . The US banks offering 12% annual (2% 90days) interest rate. The exchange rate between USD and SD is SD0.80/USD1. how Bakersfield will have after 90 days?
Money market Hedge
SD which can be borrowed SD400000=400000/1+0.02=SD392157 Bakersfield will borrow SD392157 today will covert it into USD. If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25. Now USD 490196.25 can be invested for 90 days at 2% 90days interest rate, and Bakersfield will have 490196.25x1.02=USD500000.18.
Options Hedge
Options HedgeIf the parent co. has the receivable than co. can purchase put option over the underlying currency. On the other hand if the co. has payable than co. can purchase call option over the underlying currency.
Some Alternative techniques of management of Transaction Exposure
Risk Shifting
Risk shifting does not reduce the currency risk, but it shift currency risk exposure from one co. to another by invoicing the payments in convenience currency or home currency. For example if Pepsi (USA) accept all its receivables from Pepsi (India), it means Pepsi (USA) has shifted dollar exposure to Pepsi (India).
Some Alternative techniques of management of Transaction Exposure
Exposure nettingIt techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.
Cross hedgingWhen derivative contracts are not availabe over some particular currency, but a company has exposure in that currency, then co. hedge its exposure through by purchasing derivative contracts over some another currency, this process is called cross hedging.
Some Alternative techniques of management of Transaction Exposure
Currency risk sharingCurrency risk sharing can be implemented by developing a customized hedge contract embedded in the underlying trade transactions. The hedge contract takes the form of a price adjustment., whereby a base price is adjusted to reflect certain exchange rate changes. For example, the base price is $10m, but trading parties would share the currency risk beyond a neutral zone. The neutral zone represents the currency range in which risk is not shared.
Economic Exposure
Economic exposure is based on the extent to which the value of the firm as measured by the present value of its expected future cash flows, will change with the fluctuations in the exchange rate. Economic exposure can be separated into two components-transaction exposure and operating exposure.
Management of Economic Exposure
Techniques of management of economic exposure:
1. 2. 3. 4. 5. Option market hedge Future market hedge Forward market hedge Selection of convenient currency Selection of some hard market where value of the currency of that country does not change much.
Economic exposure..example
The revenue and cost information of XYZ ltd is given as follow.
C$=%0.75 USA (in $) Sale Cost of good sold Operating expenses US: Fixed op Variable Interest expenses C$=$0.80 C$=$0.85 Canada(in Canada(in Canada(in USA (in $) USA (in $) C$) C$) C$) 300 4 304 4 307 4 50 200 50 200 50 200 30 10% of total sale 3 30 10% of total sale 0 10 3 0 0 30 10% of total sale 3 0
10
10
Q. How the cost and revenue and earning of XYZ will change under three different exchange rates scenarios?
Economic exposure..example
Canada business is translated into the US dollar the consolidated balance sheet of the XYZ ltd ltd will be under the three exchange rate scenarios.
C$=$0.75 Sale US Canada(inUS$) Total Cost of Good sold US Canada(inUS$) Total Gross Profit Operating expenses US: Fixed US: variable 10% of total sale Total EBIT Interest expenses US Canada(inUS$) Total EBT 50 150 200 103 30 30.3 60.3 42.7 3 7.5 10.5 32.2 50 160 210 97.2 30 30.72 60.72 36.48 3 8 11 25.48 50 170 220 90.4 30 31.04 61.04 29.36 3 8.5 11.5 17.86 300 3 303 304 3.2 307.2 307 3.4 310.4 C$=$0.80 C$=$0.85
Note: Variable expenses-0.10*303=30.3 0.10*307.2=30.72 0.10*310.4=31.04
Economic exposure..example
The revenue and cost information of ABC ltd is given as follow. US (in US $) Newzealand (in NZ$) Sale 800 800 Cost of good sold 500 100 gross profit 300 700 Operating expenses 300 0 EBIT 0 700 Interest expenses 100 0 EBT -100 700
Q. How the cost and revenue and earning of ABC will change under three different exchange rates scenarios- (1) NZ$=$0.50, (2) NZ $=$0.55, (3) NZ$=$0.60?
Economic exposure..example
When Newzealand business is translated into the US dollar the consolidated balance sheet of the ABC ltd will be under the three exchange rate scenarios.
NZ$=$0.50 Sale US (in US$) Newzealand (in US$) Total Sale Cost of good sold US (in US$) Newzealand (in US$) Total cost of good sold gross profit (sale-cost of good sold) Operating expenses US (in US$) Newzealand (in US$) Total operating expenses EBIT (gross profit-op exp) Interest expenses US (in US$) Newzealand (in US$) EBT (EBIT-int exp) 800 400 1200 500 50 550 650 300 0 300 350 100 0 250 800 440 1240 500 55 555 685 300 0 300 385 100 0 285 800 480 1280 500 60 560 720 300 0 300 420 100 0 320 NZ$=$0.55 NZ$=$0.60
Investing in International Market-Euro market
Benefits of International Investing In comparison to investment in domestic market, there are number of advantages of investment in international market.
?International Diversification
Diversification is process, where funds are not invested in one security or one market, rather funds are widely diversified among securities and different markets. Through diversification a fund manager can reduce the overall risk of the portfolio.
Benefits of International Investing
International beta is used to measure the risk of a country and on the basis of beta value risk of international portfolio is diversified. Foreign Market beta value is calculated in the following way:
S tan dard deviation of Foreign Market Correlation with US stock Market v S tan dard deviation of USmarket
Benefits of International Investing
?High Rate of Returns in Emerging Markets
Emerging markets are offering high returns in comparison to developed stock markets. The fund mangers can take the advantage of investment in these markets. ?Tax Advantages Investment in some stock market is not subject to tax, so fund managers are taking the advantage of tax in investing in these stock markets.
Euro Market
Euro market refers raising capital from international market by issuing the financial securities denominated in the foreign currencies. These financial securities which are denominated in the foreign currency are commonly called euro issue. Some of the euro issues are: ? ADR (American Depository Receipt) ? European Depository Receipt) ? Global Depository Receipt) ? Indian Depository Receipt) ? FCCB (Foreign currency convertible bonds) ? Sub Account ? Participatory notes
International Bond Investing
Bonds are a debt instrument which are issued for a certain period of time and promises to give fixed yield. The benefits of international diversification extend to bond portfolios as well. In international market mainly two types of bonds are available. 1.Foreign Bond2. Euro Bond-
1. Bonds in International MarketI. Foreign BondsInfosys Tec. (Foreign Co.) US Dollar denominated Bonds
Foreign Bonds
US Market (Investors)
A bond that is issued in a domestic market by a foreign entity, in the domestic market's currency. Foreign bonds are regulated by the domestic market authorities. Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure.
2. Euro BondsInfosys Tec. (Foreign Co.) Yen denominated Bonds US Market (Investors)
Euro Bonds
A bond issued in a currency other than the currency of the country or market in which it is issued. Usually, a euro bond is issued by an international syndicate and categorized according to the currency in which it is denominated. A euro dollar bond that is denominated in U.S. dollars and issued in Japan by an Australian company would be an example of a euro bond. The Australian company in this example could issue the euro dollar bond in any country other than the U.S.
American Depository Receipt
If a foreign firm plans to issue its common equity shares in US market, it can issue through ADR in US capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in US market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the US market.
American Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
US Market
NYSE
International Bank
Re/$ Dividends in US Dollar
Depositories
US Investors
Europe Depository Receipt
If a foreign firm plans to issue its common equity shares in Europe, it can issue through EDR in European capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in Europe market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the European market.
European Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
London Market
London St. Mkt
International Bank
Re/£ Dividends in pounds
Depositories
U.K. Investors
Global Depository Receipt
If a foreign firm plans to issue its common equity shares in global market , it can issue through GDR in global capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in global market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the global market.
Global Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
X Market
X Mkt
International Bank
Re/X Dividends in pounds
Depositories
XY Investors
Participatory Notes
Participatory notes are issued by listed stock brokers to those investors or other brokers which are not listed with any particular stock market but they want to invest in that stock market. If some stock broker is listed with any stock market, that stock broker is bound to make all disclose to the regulatory authority of the stock market regarding the income source of their clients. If any investor or stock broker does not want to disclose its source of income they can invest through the participatory notes.
Foreign Currency Convertible Bonds
Foreign currency convertible bonds are issued by domestic firms in the international market in some foreign currency. FCCB are convertible bonds and issued with this option that on the maturity the bonds will be converted into common equity shares .
Sub Accounts
Generally big brokers are listed with the stock market so they have the main account with the stock market and they have to do trading as per rules and regulation of the stock market. To prevent any kind of default possibilities they have to put margin money as security with the regulator of the stock market. Sub account are offered by listed brokers to small brokers which are not directly listed with the stock market.
Offshore bonds
An offshore bond is a tax efficient wrapper that can hold a variety of assets like stocks and shares or mutual funds. This is a bond that adds the legal and tax shield of a life insurance policy to an investment portfolio. It is structured to simply combine a life insurance policy and a portfolio to create a wrapper that investors can buy, manage and sell their assets through. The british (or onshore) equivalent is called an µopen ended investment company¶ (oeic). Although many oeics are shared, some are private to an individual and thus a good comparison to offshore portfolio bonds.
Offshore bonds«cont
The specific benefits of investing in offshore bonds depend upon your individual circumstances. The investment funds held within offshore bonds grow free of year-on-year taxation, unlike comparable OEICs, which are taxed annually on capital growth. You won't be liable for capital gains tax when you sell a profitable fund to purchase another fund within your offshore portfolio bond. If you made the same switches within an oeic, or your equity or unit trust investments outside a portfolio bond, you may be liable for capital gains tax. This is one way that offshore bonds are often a more taxefficient way for you to invest. Offshore bonds offer regular withdrawals, that give you access to your capital in the most tax-efficient way by withdrawing up to five percent of each investment amount every year as tax-deferred 'income'.
Portfolio Risk and Return
Portfolio is combination of different types of securities. Portfolio Return
Portfolio return is the weighted average return of individual securities in the portfolio, symbolically which can be written as:
N
R p ! § wi Ri
i !1
Where, Rp is portfolio return, wi is weightage given to each security, Ri is individual security return.
Portfolio Risk and Return
Portfolio Risk
Portfolio risk is the weighted average risk of individual securities risk in the portfolio.
N
W p ! § wiW i
i !1
Where, W p is portfolio risk, wi is weightage given to each security, W i is individual security risk.
Portfolio Risk and Return in two securities case
Wipro Return Risk (SD) Investment Weight Portfolio Return Portfolio Risk 4% 2 20000 (2000/7000)=0.29 Infosys 6% 4 50000 (50000/70000)=0.71
R(wipro)*w+R(Infosys)*w 4*0.29+6*0.71=5.42% SD(wipro)*w+SD(infosys)*w 2*0.29+4*0.71=3.42
Return of this portfolio is 5.42 percent and risk is 3.42.
Portfolio Return and Risk in more than two securities case
Total Investment 1,00,000 Wipro Return Risk (SD) Investment Weight Portfolio Return Portfolio Risk 2% 2 10000 0.10 Infosys 3% 4 20000 0.20 ABB 2% 3 25000 0.25 TCS 5% 2 25000 0.25 SBI 6% 3 20000 0.20
2*0.10+3*0.20+2*0.25+5*0.25+6*0.20=3.75% 2*0.10+4*0.20+3*0.25+2*0.25+3*0.20=2.85
Return of this portfolio is 3.75 percent and risk is 2.85.
Optimal International Allocation
Optimal international allocation refers how much money should be invested in which security. The modern portfolio theory states that allocation of funds into different securities depend upon the risk-return trade off of the investors. To earn high returns, investor will have to invest in high risky portfolios. The modern portfolio theory calls it efficient market frontier, which states the relationship between risk and return in efficient capital market.
Effect of diversification on portfolio risk
Diversification is a process which includes putting more and more security in the portfolio and thereby reduction of portfolio risk. It can be shown in the figure-
Portfolio Return and Risk
Total Fund=$1,00,000 Stock-1 Return 2% Risk (Stdev) 2 Money Invested 10,000 Portfolio Return= 0.10*2 + Stock-2 3% 4 20,000 0.20*3 + Stock-3 2% 3 25,000 Stock-4 5% 2 25,000 Stock-5 6% 3 20,000 + 0.20*6 =3.75% +0.20*3 = 2.85%
0.25*2 + 0.25*5
Portfolio Risk= 0.10*2
+
0.20*4
+ 0.25*3 + 0.25*2
International Portfolio Return and Risk When portfolio also consists risk free securities Total Investment Rs 200000
1. Risky Securities
? ? ? ? ? 1. Equities 2. International Bonds 3. Mutual Funds 4. Derivatives 1. Govt. Bonds 2. Treasury Bills 3. Bank deposits Return 6% 2% 3% 4% 3% 2% 2% Risk ( ) 4% 2% 3% 2% Invest. W 10000 0.050 15000 0.075 25000 0.125 50000 0.250 25000 25000 50000 0.125 0.125 0.250
2. Risk Free Securities
? ?
Port. Ret = 6x0.050+2x0.075+3x0.125+4x0.250+3x0.125+2x0.125+2x0.250=2.95% Port. St.dev = 4x0.050+2x0.075+3x0.125+2x0.250=1.22
Country Risk Analysis
Country risk analysis is the potential risk and reward associated with making investments and doing business in a country. Country risk is bigger concept than the political risk. Country risk includes any kind of threats prevailing in the country. It can be economic threats, national security threats, political threats etc.
Political Risk in Foreign Investment
Foreign investment is very sensitive to the potential political risks of foreign exchange control and expropriation. Political risk can influence the investment in foreign market in terms of: 1.Blocked fund
Blocked fund is a situation when the govt. of the host country put control over the convertibility of host currency into foreign currency and transfer of foreign currency out of host country.
2. Expropriation
Expropriation is a situation when host govt. may reduce or eliminate ownership or control over some project in the foreign country. Expropriation is some process of doing nationalization of project.
Measuring Political Risk
Impact of political risk can not be quantified however by analyzing some factors the impact of political risk can be gauged. These factors are: 1. Political stability 2. Economic stability 3. Attitude of govt. towards foreign capital 4. Subjective factors
I. Political risk and uncertain property rights-If govt. is entitled to acquire any private property and nationalize it, it means political risk is there in that country. II. Capital flight-capital flight refers to the export of savings by a nation¶s citizens because of fears about the safety of their capital. If capital flight situation is there in any country, it means political risk is there in that country.
Economic and Political Factors Underlying the country risk
1.Fiscal irresponsibilityFiscal refers irresponsibility imposing high taxes on the corporate and individuals. 2. Monetary irresponsibilitymonetary irresponsibility refers high interest rates, and inflation in the economy. 3. Controlled exchange ratewhen the govt. has control over the exchange rate instead of having market determined rates. 4. Wasteful govt. spending 5. Resource base of the country 6. market oriented versus static policies
Financing Foreign Trade
Financing of foreign trade refers the methods of payment of exported goods.
Payment Methods for International Trade
Letters of credit (L/C)
? These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents. ? Time of payment : When shipment is made ? Goods available to buyers : After payment ? Risk to exporter : Very little or none ? Risk to importer : Relies on exporter to ship goods as described in documents
Trade Finance Methods
Letters of Credit (L/C)
± These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents. ± The importer pays the issuing bank the amount of the L/C plus associated fees. ± Commercial or import/export L/Cs are usually irrevocable.
Payment Methods for International Trade
Open Accounts
? The exporter ships the merchandise and expects the buyer to remit payment according to the agreed-upon terms. ? Time of payment : As agreed upon ? Goods available to buyers : Before payment ? Risk to exporter : Relies completely on buyer to pay account as agreed upon ? Risk to importer : None
Documents in International Trade
The following documents are need in international trade.
Bill of Lading
It is a contract between the carrier and exporter in which the carriers agrees to carry the goods from port of shipment to port of destination. Bill of lading includes±Details of merchandise ±Details of exporter and importer ±Details of mark on the merchandise ±Date of shipment ±Date of delivery ±Details of freight charges and other charges. ±Details of the liability of carrier.
Documents in International Trade
3. Insurance Certificate All cargoes going to abroad are insured. The policy of insurance covers all shipments made by the exporters. 4. Consular certificate Exports to many countries requires a special consular invoice. This invoice which varies the details and information requirements from nation to nation.
International Cash Management
Cash management is process which involves keeping the optimum level of cash at some point of time and investing the excess cash in different short term securities. Cash management involves the followings:
International Cash Management
1. 2. 3. 4. Collection and disbursement of funds Netting of interaffiliate payments Investment of excess cash. Establishment of an optimal level of worldwide corporate cash balances. 5. Cash planning and budgeting. 6. Bank relations.
Collection and disbursement of funds
Procedures for expediting Receipt of Payments.
1.Cable Remittances 2.Mobilization centers 3.Lock Boxes 4.Electronic fund transfer
Procedures for expediting Receipt of Payments.
1.Cash remittances 2.Establishing a/c in customers bank. 3.Negotiating with banks on value dating.
Netting of interaffiliate payments
Netting of interaffiliate payments is the process wherein the netting of the cash is done among the subsidiaries of the same parent company.
Payments flows before Multilateral /Bilateral netting
$20,00,000 Dutch Affiliate $70,00,000 Swedish Affiliate
$30,00,000
$80,00,000 $20,00,000 $20,00,000
$60,00,000
$50,00,000
French Affiliate
Belgian Affiliate
Payments flows after Multilateral/Bilateral netting
Paying Affiliates Receiving Affiliate Netherlands France Sweden Belgium Total Payments Netherlands France Sweden Belgium Total Receipt Net Receipt/Payment
x 6 2 1 9
8 x 0 2 10
7 4 x 5 16
4 2 3 x 9
19 12 5 8 44
10 2 -11 -1
Dutch Affiliate
$90,00,000
Swedish Affiliate
French Affiliate
Belgian Affiliate
Pooling in Multilateral Netting
Multilateral netting requires a central controlled point that can collect and record detailed information on the intra corporate accounts of each participating affiliate at specified time interval. The control point called pooling or netting centre, is a subsidiary set up in a location with minimal exchange controls for trade transactions.
Short term Financing Options
1.Intercompany financing: Intercompany financing refers when one subsidiary provide credit to another subsidiary. 2.Local currency financing:
Local currency financing can be done in the following forms. 1. Bank Loan- Banks provide credit in the form of following forms-Term Loan, Overdraft, Discounting of bills. 2. Commercial Papers-Commercial papers are short term instruments which are used to raise capital.
3. Insurance Certificate
All cargoes going to abroad are insured. The policy of insurance covers all shipments made by the exporters.
4. Consular certificate
Exports to many countries requires a special consular invoice. This invoice which varies the details and information requirements from nation to nation.
doc_829554198.ppt
International finance deals with the management of international financial flows, institutions, and foreign exchange rate between the two currencies. Functions of International Finance: Investment DecisionsInvestment decisions deals with the investing efficiently in overseas markets.
Finance decisionsFinance decisions deals with the raising of finance from international markets.
International Monetary System
The international monetary system refers to the policies, institutions, practices, regulations and mechanism that determines the rate at which one currency is exchanged for another.
The International Monetary System Consists
Policies related to the foreign exchange rate Institutions which monitor the exchange rate Practices regarding the management of forex rate Regulation regarding the management of forex rate Mechanism of the management of the forex rate
History of International Monetary System
Classical gold Standard
Under the gold standard, the currency which was in circulation consist or represents certain amount of gold. It was the oldest system which was in operation till the beginning of the 1st world war (1931). Under this system, the actual currency in circulation consists of coins with a fixed gold content.
Determination of Exchange Rate under Gold Standard
Exchange rate determination depends upon, currencies consist how much gold. Suppose, a pound sterling is worth 0.05 ounces of gold in the UK, and dollar is worth equal to 0.00125 ounces of gold in the US. Then the exchange rate between pound sterling and dollar would be 4.00dollar equal to 1 sterling pound.
International Monetary System
The Bretton Wood System (1946-1971)
To come up the depressed economy after world war 2nd, the US and UK and other countries agreed to overhaul the world monetary system to accelerate the international trade. The outcome was so called Bretton Wood System which become the cause of establishing International Monetary Fund (IMF) and World Bank in 1946.
The Bretton Wood System«cont
The exchange rate regime that was put in place can be characterized as the Gold Exchange Standard continued till 1971. Under this system the main mechanism of exchange rate was:
The US govt. undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce. Other member of IMF agrees to fix the exchange rate of their currencies against dollar with the variation within 1% on either side of the central parity being permissible.
International Financial Institutions
Under the Bretton Wood System two major financial institutions were established in 1946.
± International Monetary Fund ± International Bank for Reconstruction and Development (World Bank)
IMF
IMF was established to promote the financial stability among the member countries. The currency of the IMF is SDR (Special Drawing Rights). It is a currency basket whose value is the weighted average of the currencies of five countries (Germany, France, Japan, England, USA) The main roles of IMF are:
± To monitor the exchange rate policies of the member countries. ± To advise the developing countries about their monetary stability. ± To act as the lender of last resort-It means if member countries fails to avail financial help from any where than IMF would provide the financial help on concessional basis. ± To provide financial help to recover the balance of payment deficit.
World Bank
World Bank provide the financial assistance to the member countries for development purposes. To provide the long term loan to developing countries. IDA (International Development Association) which is known as soft window of loan of world bank provide long term loan to developing countries at highly subsidized rates. To provide financial assistance for Infrastructure projects.
Role of Bank for International Settlements
Role of BIS:
? Bank for International Settlements acts as the central bank for the industrial countries central banks. ? BIS helps central banks to manage and invest their foreign exchange reserves. ? BIS also coordinates with IMF on behalf of the member countries.
Post Bretton Wood System-Alternative Foreign Exchange Rate System
Foreign exchange rate system deals with how foreign exchange rate between two currencies is determined.
Fixed Exchange Rate system
Floating Exchange rate system Foreign Exchange rate system Managed Float system
Mixed Exchange rate system
Fixed Exchange rate system
Fixed exchange rate system is that exchange rate system where exchange rate is directly regulated by central bank, and it is determined accordingly. Under fixed exchange rate system, demand and supply forces have no role in determine the exchange rate.
$/Re S-forex
$/Re
D-forex
Reserve of Forex
Floating Exchange rate system
Floating exchange rate system is that exchange rate system where exchange rate is directly determined by demand and supply forces.
Demand for Foreign currency1.Importers 2. Gifts to abroad 3. Remittance to abroad 4.Financial Assistance to abroad. 5. Investment in foreign currency denominated assets.
$/Re
S-forex
$/Re D-forex
Supply for foreign currency? Exporters. 2. Gifts to home country. 3. Remittance to home country. 4. Financial assistance to home country. 5. Investment in home country .
Reserve of Forex
Managed Float Exchange Rate System
Managed float exchange rate system is that exchange rate system wherein the exchange rate is deliberately determined or fixed. Generally it is of two typesCrawling Peg exchange rate systemTarget Zone exchange rate system-
Crawling Peg Exchange Rate System
Crawling peg exchange rate system is also called managed float exchange rate system. It is that exchange rate system where foreign exchange is directly determined by central bank of the country. But in this exchange rate system, exchange rate is frequently adjusted depending upon the market requirements.
$/Re
$/Re
Reserve of Forex
Targeted Zone Exchange Rate System
In targeted Zone Exchange Rate System, Exchange Rate is kept at desired level by adjusting the all economic and commercial policies.
$/Re 52/1$ S-forex
45/1$ D-forex
Reserve of Forex
Mixed Foreign Exchange
Mixed exchange rate system is combination of fixed exchange rate system and floating exchange rate system. Under this system imports and exports of some items are subject of fixed exchange rate and imports and exports of some items are subject of floating exchange rate.
For exampleIn India the imports and exports of current a/c items are subject of floating rate. Importers and exporters are free to purchase and sell the foreign currency from open market. The imports and exports of capital a/c items are subject of fixed exchange rate. Importers and exporters have to purchase and sell the foreign currency at govt. determined exchange rate.
European Union and Monetary System
The European Monetary System began operating in 1979. Its objective was to foster monetary stability in the European Union. European Union consists 25 member countries. As of January 1999, common currency called Euro introduced in 11 courtiers for the purpose of commercial transactions and to accelerate the international trade among the member countries. Of late by June 2002, one more country currency replaced with Euro. The 12 countries are-Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, and Spain.
Impact of Single Currency on EU
1.Impact on European Monetary Policy
The euro allows for a single money supply throughout much of Europe, rather than a separate money supply for each member countries. The common currency promoted the political and economic ties among the member countries. The introduction of euro calls establishment of European Central Bank in Frankfurt and is responsible for setting monetary policy for all member countries.
Impact of Single Currency on EU«cont.
2. Impact on European Business
Adoption of common currency eliminated the currency movements among European countries, and also encourages more long term business arrangements between companies of two countries. Trade flows between member countries have increased because exporters and importers can conduct trade without having concern about exchange rate fluctuations.
Impact of Single Currency on EU«cont.
3. Impact on Financial Movements
A single euro forces the interest rate on govt. securities identical among the member countries. Any mismatch in interest rate foster the fund movements from one country to another country. Stock prices in member countries are also comparable because they are denominated in the same currency.
Impact of Single Currency on EU«cont
4. Impact on Exchange Rate Risk
Adoption of common currency is the advantage of elimination of foreign exchange rate risk. Besides it, the foreign exchange transactions cost have also eliminated.
Foreign Exchange Market
Foreign exchange market is that market where foreign currencies are traded at spot price or future price. Participants in Foreign Exchange Market-
Participants in Foreign Exchange Market1. Foreign Exchange Brokers- Foreign Exchange brokers are those entities which are ready to buy and sell the foreign currency. 2. Arbitrageurs- Arbitrageurs are those entities which take advantage of foreign exchange rate differential in two markets. USA Forex Market-For example in USA lets assume-Re.48/ $1 and in India Forex Market-Re.50/$1then arbitrageurs will start to purchase dollar in U.S stock market and sell it in Indian forex market. 3. Speculators- Speculators are those who take advantage of speculation in Forex Market. 4. Traders- These are entities which are in the business of export and import. 5. Hedgers- mostly multinational firms, engage in forward contracts to protect the value of outstanding contracts.
Transactions in Fx Market
All the transactions in foreign exchange market either take place at spot rate which is called spot market or forward rate which is called forward foreign exchange market.
Spot Foreign Exchange Market Foreign Exchange Market Forward Foreign Exchange Market
Transactions in Spot Market
Spot foreign exchange market is that market where currency is delivered at prevailing foreign exchange rate.
Spot Quotations in Foreign Exchange Market
Direct QuotationsIn foreign exchange market direct quotations exist when value of one unit of foreign currency is expressed in certain units of domestic currency. For example Re. 50/1$
Indirect QuotationsIn foreign exchange market indirect quotations exist when value of one unit of domestic currency is expressed in certain units of foreign currency. For example $0.02/Re 1
Transactions in Forward foreign exchange market
Forward foreign exchange market is that market where currency is delivered at some future date at an agreed price.
Forward Quotations
Forward quotations refers the way in which the value of foreign currency is expressed in some future date.
Forward Premium
When dealing with foreign exchange (FX), forward premium is a situation where the futures exchange rate, with respect to the domestic currency, is trading at a higher spot exchange rate. In other words forward rate is higher than the spot rate.
Forward Pr emium ! 360 Forward Rate Spot Rate v Spot Rate Forward Contract No. of days
Suppose spot Yen on Dec 3, 2001 sold at $0.008058, whereas 180 days forward Yen were priced at $0.008135. It means Yen is quoted 77 point premium. The annualized forward premium is:
Forward Pr emium ! 0.008135 0.008058 360 v ! 0.0191 or 1.91% 0.008976 180
Forward Discount
When dealing with foreign exchange (FX), forward discount is a situation where the futures exchange rate, with respect to the domestic currency, is trading at a lower spot exchange rate.
Forward Discount ! Forward Rate Spot Rate 360 v Spot Rate Forward Contract No. of days
Suppose the British pound was quoted $1.4248 while the 90 days forward pound was quoted at $1.4179. It means the pound is quoted 69 point discount. The annualized discount is:
Forward Discount ! 1.4179 1.4248 360 v ! 0.0194 or 1.94% 1.4248 90
Bid, Ask and Spread
Bid is that quotation at which foreign currency is purchased. Ask is that quotation at which currency is sold. Suppose pound is quoted at $1.4419-28. It means that banks are ready to purchase pound at $1.4419 and ready to sell at $1.4428. Spread is the difference between the bid price and ask price. For example if ask price for pound is $1.4428 and Bid price is $1.4419, then the spread will be:
Percentage Spread ! Ask Pr ice Bid Pr ice Ask Pr ice
1.4428 1.4419 v 100 ! 0.062% 1.4428
Percentage Spread !
Calculation of Forward rate from spot rates
What will be 30days and 60days forward rates ? Spot rate 30days 60 days ($/Bp): 2.20-30 10-20 30-20 Ans. 30 days forward rates will be: ($/BP): 2.30/2.50 60 days forward rates will be: ($/BP): 1.90/2.10
Notes: if exchange rates are expressed in such a manner, it is also called swap rates or outright rates. If swap rates are in increasing order just like in the case of 30 days. Then then points are added in spot bid and ask rate respectively. On the other hand if swap rates are in decreasing order, just like in the case of 60 days, then swap points are deducted from spot rates respectively.
Cross Rates with zero transaction cost
Cross Rates refers when exchange rate between two currencies is determined with the help of third currency with which the two currencies have exchange rate.
If $0.90/ ¼, then ¼1.11/ 1$, in the same way if $0.60/SFr, then SFr1.66/1$ The exchange rate between Euro and Swiss Franc will be-¼1.11=SFr1.66 or SFr1.49/1$
Cross Rates with positive transaction cost
Q. 1. spot rates are given as: $/euro: 1.3520/1.3550 $/BP: 2.0250/2.0285 What will be cross/synthetic rates ?
bid rate of Euro ! $ / euro : 1.3520 ! BP0.6665 / euro or euro1.50 / 1BP $ / BP : 2.0285 $ / euro : 1.3550 ! BP0.6691 / euro or euro1.49 / 1BP $ / BP : 2.0250
ask rate of Euro !
Cross/synthetic rates will be: BP/euro: BP0.6665/0.6691
Cross Rates with positive transaction cost
Q. 1. spot rates are given as: $/Bp: 1.4419-36 $/SFr: 0.6250-67 What will be cross/synthetic rates ?
bid rate of BP ! $ / BP : 1.4419 ! SFr 2.3007 / BP $ / SFr : 0.6267 $ / BP : 1.4436 ! SFr 2.3097 / BP $ / SFr : 0.6250
ask rate of BP !
Cross/synthetic rates will be: SFr/BP: 2.3007/2.3097
Currency Arbitrage
Currency arbitrage is a situation which involves purchasing a currency from a market where it is available at cheap rate, and selling the same currency where it is trading at higher rate. Type of arbitrage: 1 One point arbitrage: 2. Two point arbitrage 3. Three point arbitrage:
One point arbitrage
One point arbitrage implies purchasing currency at lower price and selling the same currency at the higher price in the market. If USD/BP :1.24/1.30 It means arbitrage can purchase 1 BP at 1.24 and sell at 1.30 for one dollar. The profit of arbitrageur from this arbitrage is USD0.06.
Indirect quotes and Two Point Arbitrage
Bank A is quoting in USA:
USD/BP: 1.4550/1.4560 It means bid rates of banks are $1.4550 for 1BP, and $1.4560 is ask rate for 1BP
Bank B is quoting in UK
USD/BP: 1.4538/1.4548 It means bid rates of banks are $1.4538 for 1BP, and $1.4548 is ask rate for 1BP Now arbitrate opportunities are there, arbitrageur will purchase 1BP from UK at $1.4548 and sell at $1.4550 in USA. Net profit will be (1.4550-1.4548)=$0.0002
Triangular Arbitrage
Suppose pound is bid at $1.5422 in New York and euro is offered at $0.9251in Frankfurt. At the same time London banks are offering pound at Euro1.6650.
$1.5422/1BP (New York) $0.9251/1Euro (Frankfurt) Euro1.6650/1BP (London) 1 2 3
Let¶s examine whether arbitrage opportunities exist or not:
As we known 1 and 3 are equal. $1.5422=Euro1.6650 or $0.9260/1Euro
But in Frankfurt the exchange rate between dollar and euro is $0.9251, it means arbitrage opportunities exists.
Triangular Arbitrage«cont
New York $1.5422/1BP
Sells Pound in New York at $1.5422/1Pound for $1,001,239.05 (649227.76*1.5422)
Arbitrager acquires $1million in New York
London Euro1.6650/1BP
Sells euro1,080964.22 in London at euro1.6650/1pound for Pound649227.76 (1080964.22*0.600)
Frankfurt $0.9251/1Euro
Sells $10,00,000 in Frankfurt at $0.9251/1euro for euro 1,080964.22 (10,00,000*1.080964)
Net Profit from Arbitrage=$1,001,239.05-10,00,000=$1239.05
Triangular Arbitrage with positive transaction cost
The bid and ask rates of different currencies are given in three different markets. Is there any arbitrage opportunities? JY/$:110.25/111.10 R/$:1.6520/1.6530 JY/R:68.30/69.50 There will be no arbitrage opportunities if the following condition is holding true:
1 * bid ( R / $) * bid ( JY / R) e 1 ask ( JY / $)
1 *1.6520 * 68.30 ! JY1.015 111.10
The calculated value 1.015 is more than 1, it means arbitrage opportunities are possible. If we start with JY 10,0000, than finally we will haveJY10,00,000*1.015=JY101500
Triangular Arbitrage with positive transaction cost
The bid and ask rates of different currencies are given in three different markets. Is there any arbitrage opportunities? Value of BP in USD:$1.60/$1.61 Value of Real in USD:$0.200/$0.24 Value of BP in Real: R8.10/R8.20 There will be no arbitrage opportunities if the following condition is holding true:
1 * bid ($ / R) * bid ( R / BP ) e 1 ask ($ / BP)
1 * 0.200 * 8.10 ! $1.0062 1.61
The calculated value 1.062 is more than 1, it means arbitrage opportunities are possible. If we start with $10,0000, than finally we will have$10,00,000*1.062=$1006200
Foreign Exchange Derivative Market
Foreign exchange derivative market is that market where such kind of financial instruments are traded which are used to hedge the foreign exchange risk. MNCs which have global business operation are getting their sales in multiple currencies. So large and unexpected fluctuations in exchange rate between domestic currency and host currency will expose the company to the foreign exchange risk. To the hedge the foreign exchange risk MNCs and other investors purchase derivative contracts.
Forward Market
A forward contract is a contract in which currency is delivered in future date at an agreed price.
Features 1. Non Standardized Contracts. 2. Traded at over the counter the market. 3. Fear of Default. 4. No involvement of third party. 5. Party known to each other very well.
Futures Contract
A future contract is contract in which seller agrees to make delivery of specified amount of currency at specified future date at specified exchange rate. A Future contract is stated in details. Under Future contract both the parties have to put a margin money to clearing house. In case of default the margin of the respective party is seized.
Features ±
1. Standardized Contract. 2. Between two parties who not necessarily known to each other. 3. No default, guarantee for performance by a clearing corporation or clearing house. 4. Margin placement to the clearing house.
Future Contracts
Future Contracts Commodity Future Financial Future
Futures on Stocks
Stock Index Futures
Foreign Ex. Futures
Interest rate Futures
Application of the Future Contracts
Hedging Hedging involves wherein exporters, importers and firms need foreign currency purchase future contract to avoid the unexpected fluctuations in the forex markets. Trading Future contracts are financial products which are used for trading purposes. Traders are purchasing and selling future contracts mearly for trading purpose.
Application of the Future Contracts«cont
Speculation Speculators take advantage of Forex market fluctuations by purchasing the currency futures. International Spreading
When there are expectations that two Forex will not covary in the same directions then International spreading like Straddle or Strangle can be created to utilize this situations.
Arbitrage Between two stock Exchanges
Arbitrager is a process of taking advantage of price differential of two Forex markets.
Options
Call Option on Currency
A call option is that agreement in which the writer or seller gives the right to purchase a specified amount of currency at specified exchange rate to the option buyer or investor. A call option is purchased to minimize the risk of hiking the price of underlying currency.
Call Options are purchased to hedge the upside risk.
Top to Bottom
Calculation of Profit/Loss of Investor on Call Option
Call Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.
60K 40K 20K 44 20K 40K 50K 60K 46 48 50 52 54 56
Spot Ex. Rate 44/$
Spot Ex rate
Gross Net Profit/Loss Profit/Loss -20000 -20000 -20000 -20000 20000 40000 60000 -20000 -20000 -20000 -20000 0 20000 40000
46/$ 48/$ 50/$ 52/$ 54/$ 56/$
Profit/Loss of Investor
Calculation of Profit/Loss of Writer on Call Option
Call Option-Contract Size $10,000, Exercise Price 50/$, Option Premium 2/$, Maturity Period 3 months.
Spot Ex. Rate 44/$ 46/$
44 46 48 50 52 54 56
60K 40K 20K 0 20K 40K 50K 60K
Gross Profit/Loss 20000 20000 20000 20000 -20000 -40000 -60000
Net Profit/Loss 20000 20000 20000 20000 0 -20000 -40000
48/$ 50/$ 52/$ 54/$
Spot Ex rate
Profit/Loss of Writer
56/$
Put Option
A put option is that agreement in which the writer gives the right to sell the specified amount of foreign currency at specified exchange rate to the option seller or writer. A put option is purchased to minimize the risk of declining the price of underlying currency. Put Options are purchased to hedge the downside side.
Put Option
Contract Size $10,000 Exercise Price 45/$ Option Premium Rs 4/$ Maturity Period 3 months
Bottom to Top
Calculation of Profit/Loss of Investor on Put Option
Contract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.
Spot Ex. Rate 46/$ 48/$
46 10K 20K 30K 40K 48 50 52 54 56 58
30K 20K 10K 0
Gross Net Profit/Loss Profit/Loss 60000 40000 20000 -20000 -20000 -20000 -20000 40000 20000 0 -20000 -20000 -20000 -20000
50/$ 52/$ 54/$ 56/$
Spot price
Profit/Loss of Investor
58/$
Calculation of Profit/Loss of writer on Put Option
Contract size $10,000, Exchange rate 52/$, Option Premium, 2/$, Maturity Period 3 months.
Spot Ex. Rate
30K 20K 10K 46 10K 20K 30K 48 50 52 54 56 58
Gross Profit/Los s -60000 -40000 -20000 20000 20000 20000 20000
Net Profit/Los s -40000 -20000 0 20000 20000 20000 20000
46/$ 48/$ 50/$ 52/$ 54/$ 56/$
Spot price
Profit/Loss of Writer
58/$
Types of Options
American Call Options American Options Options European Call Options European Options European Put Options American option-American option can be exercised at any time with the maturity period. European option-European option can not be exercised before the maturity period. American Put Options
Financial Swaps
Financial swaps is a process in which two business organization change their financial obligation. Financial swaps are widely used by MNCs, Banks and Govts. Minimize the credit and currency risk. Financial swaps take place against a notional amount.
Measuring Exchange Rate Movements
? An exchange rate measures the value of one currency in units of another currency. ? When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate. ? On the days when some currencies appreciate while others depreciate against a particular currency, that currency is said to be ³mixed in trading.´
Measuring Exchange Rate Movements
? The percentage change (% (
in the value of a foreign currency is computed as
St ± St ± 1 St ± 1 where St denotes the spot rate at time t.
? A positive % ( represents appreciation of the foreign currency, while a negative % ( represents depreciation.
Determination of Exchange Rate
Exchange rate between two currencies is determined on the basis of demand and supply forces. It means where demand for foreign currency curve will intersect the supply curve of foreign currency, the exchange rate will be determined at that level.
Derivation of Demand curve for Foreign currency
The demand for foreign currency is inversely related to the exchange rate. At higher exchange rate, there will be less demand for foreign currency. At lower exchange rate, demand for foreign currency will be high. It can be shown in the diagram:
Exchange rate 40/$ 42/$
Df
X1 X2 Amount of Foreign Currency
Derivation of Supply curve for Foreign currency
The supply of foreign currency is positively related to the exchange rate. At higher exchange rate, there will be high supply of foreign currency. At lower exchange rate, supply of foreign currency will be low. It can be shown in the diagram:
Sf Exchange rate 40/$ 42/$
X1 X2 Amount of Foreign Currency
Demand and Supply in Determination of Foreign Exchange Rate
In competitive foreign exchange market, exchange rate will be determined at the level where demand and supply will be equal to each other.
Demand for Foreign currency$/Re $/Re D-forex 1.Importers 2. Gifts to abroad 3. Remittance to abroad 4.Financial Assistance to abroad. 5. Investment in foreign currency denominated assets.
S-forex
Supply for foreign currency? Exporters. 2. Gifts to home country. 3. Remittance to home country. 4. Financial assistance to home country. 5. Investment in home country .
Reserve of Forex
Factors affecting the Foreign Exchange Rate
There are number of factors which determines the exchange rate between two currencies. These are:
Inflation Terms of Trade, Amount of Trade Foreign Investment Service trade, Capital Inflows
Inflation
Inflation in the home Country
If there is inflation in the home country, it means more imports will be done. In order to pay for imports, people will create more demand for foreign currency. As a result, the demand curve for foreign currency will shift toward right. The exchage rate will increase. It is shown in the figure 1.
Inflation in the host country If there is inflation in the host country, it means more exports will be done. Higher exports will generate more export earnings, as result the supply of foreign currency in the domestic economy will increase. As a result, the supply curve for foreign currency will shift toward right. The exchage rate will come down. It is shown in the figure 2.
Sf1 Exchange rate 40/$ 42/$ Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Terms of Trade, amount of trade
Terms of trade in favour home Country
If terms of trade are in favour of home country, it means more exports will be done. Higher exports will generate more foreign currency. As a result, the supply curve of foreign currency will shift toward right and vice versa. It is shown in the figure 2.
Terms of trade in favour of host country If terms of trade are in favour of host country, it means more imports will be done. In order to pay for imports, more demand for foreign currency will be created. As a result, the demand curve of foreign currency will shift toward right and vice versa. It is shown in the figure 1.
Sf1 Exchange rate 40/$ 42/$
Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Foreign Investment
Higher foreign investment in the home country
Higher foreign investment in the home country will create more inflows of foreign currency in the home country. As a result the supply of foreign currency will increase. As a result, the supply curve of foreign currency will shift toward right and vice versa. It is shown in the figure 2.
Higher foreign investment in the host country
Higher investment in the host country will create more demand for foreign currency in the home country. As a result the demand for foreign currency will increase. As a result, the demand curve of foreign currency will shift toward right and vice versa. It is shown in the figure 1.
Sf1 Exchange rate 40/$ 42/$ Sf1 Sf2
Df2 Df1
Exchange rate
40/$ 42/$
Df1
X1 X2 Amount of Foreign Currency Figure 1
X1 X2 Amount of Foreign Currency Figure 2
Determination of Foreign Exchange Rate
There are number of factors which determines the exchange rate between two currencies. These are:
Demand and Supply conditions of a currency Central Bank Intervention Govt. controls on forex rates
Factors that Influence exchange Rates
Government Controls
? Governments may influence the equilibrium exchange rate by: ± imposing foreign exchange barriers, ± imposing foreign trade barriers, ± intervening in the foreign exchange market, and ± affecting macro variables such as inflation, interest rates, and income levels.
Intervention of Central Bank
The central bank of the country have dominate role in determining the exchange rate between domestic currency and foreign currency. If central bank wants to increase the exchange rate, then central bank will start to purchase the foreign currency with domestic currency. On the other hand if central bank wants to lower down the exchange rate then central bank starts to sell the foreign currency in exchange of domestic currency in the market. In fact central bank do the intervention in the market by two ways1. Sterilization Intervention 2. Unsterilized Intervention
Sterilization and Unsterilized Intervention
In fact, when central when central bank sells the domestic currency in exchange of foreign currency in order to regulate the value of the foreign currency. It leads rise in the supply of the money in the domestic market which results inflation in the economy. So when central bank doest not insult their domestic money supply from the foreign exchange transactions, this is called unsterilized intervention. On the other hand, when central bank insult their domestic money supply from the foreign exchange transactions, this is called sterilized intervention
Sterilization Intervention
In case of sterilized intervention when central bank sells domestic currency in exchange of foreign currency it leads inflation in the economy. To check this inflation central bank simultaneously starts to absorb this excess money supply from the market through open market operation. In open market operation central bank sells short term securities like Treasury bills in the market to absorb excess liquidity. So in sterilized intervention, central bank regulate the exchange rate but at the same time insulate the inflation from the exchange rate.
Theories of Exchange Rate Determination
There are two theories which empirical examines how the exchange rate between two currencies are determined. These theories are:
Purchasing power parity theory Interest rate parity theory
Purchasing power parity theory of Exchange Rate
The theory of purchasing power parity (PPP) explains movements in the exchange rate between two currencies by changes in the price levels of respective countries.
The exchange rate between two countries¶ currencies equals the ratio of the counties¶ price levels. It compares average prices across countries. It predicts a Re/dollar exchange rate of:
Re/ $ ! Pr ice( Ind ) / Pr ice(US )
Purchasing Power Parity
?Absolute PPP and Relative PPP Absolute PPP
? It states that exchange rates equal relative price levels.
For example if in USA a basket of goods can be purchased by one dollar, and the basket of same goods can be purchased in India by Rs 50/-, the exchange rate between rupee and dollar will be 50/1$. Likewise if Burger in USA cost USD2.43 and the same burger is of BP 1.90 in England then the exchange rate between USD and BP is
USD2.43/BP1.90=USD1.29/BP1
Purchasing power parity theory of Exchange Rate«cont.
Relative PPP
? It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.
et ! 1 Pf 1 Ph 1
Where et is forward rate, Ph is price level in the home country, Pf is the price level in the foriegn country.
Relative PPP «example
For example if inflation in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:
et !
1 0.05 1 ! 0.045 or 4.5% 1 0.10
It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BP So, the exchange rate between USD and BP will be USD1.53/BP.
Relative PPP «example
For example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:
et ! 1 0.05 1 ! 0.0194 or 1.94% 1 0.03
It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFr So, the exchange rate between USD and SFr will be USD0.760/SFr.
Relative PPP «example
For example if inflation in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be: 3 month inflation in US will be = 5*3/12=1.25% 3 month inflation in Switzerland = 3*3/12=0.75%
et ! 1 0.0125 1 ! 0.0050 or 0.50% 1 0.0075
It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFr So, the 90 days forward rate will be USD 0.753/SFr.
Important slide
Real Exchange Rate
The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currencies. In other words real exchange rate is inflation adjusted exchange rate.
1 ih Where et is real exchange rate, eo is spot exchange rate, ih is inflation rate in home country, if is inflation in foreign country, t is time period. et ! 1 i f 1
Alternatively when some exchange rate is adjusted with some price index like WPI or CPI, then the real exchange rate will be:
et ! e0 ( f / h) Pf Ph
Where et is real exchange rate, eo is spot exchange rate, Ph is inflation rate in home country, Pf is inflation in foreign country, t is time period.
Calculating the Real exchange rate between USD and Japanese Yen
Between 1980 and 1995, the USD/JY moved from JY 226.63/USD 1 to JY93.96. During this 15 years, the consumer price index (CPI) in Japan rose from 91.0 to 119.2, and CPI in USA rose from 82.4 to 152.4. Q. 1. if PPP had held over the period, what would the USD/JY exchange rate in 1995?
Pf Ph 119.2 / 91.0) ! JY160.51 / USD1 (152.4 / 82.4)
et ! e0 ( f / h)
! ( 226 / 1)
Calculating the Real exchange rate between USD and Japanese Yen«cont
Q.2. What happened to the real value of the yen in terms of dollars during this time period?
Ph 119.2 / 91.0) ! (1 / 93.96) ! USD0.007538 / JY 1 Pf (152.4 / 82.4)
et ! e0 (h / f )
International Fisher Effect
International Fisher effect integrates the purchasing power parity theory and Fisher effect in explaining the behavior of exchange rate between two currencies. PPP states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels. On the other hand Fisher effect states that with no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries.
International Fisher Effect
The interest rates which are quoted for financial contracts are stated in nominal terms. According to fisher effect, the real interest rate must be adjusted to reflect the expected inflation. It states that nominal interest rate is made up of two components real required rate of return and inflation premium equal to the expected amount of inflation. The fisher equation is:
R=Required rate of return + Expected inflation R=a + i If required rate of return is 3% and inflation is 10%, then nominal interest rate must be 13%.
Fisher Effect«.cont
Fisher effect states that the real rate of return on financial contracts are equal across the countries that is: af=ah If expected real returns is higher in one currency than another than capital flow would flow from the second country to first country. In equilibrium then no government intervention, the nominal interest rate differential will approximately equal the anticipated inflation differential between the two countries.
Rh R f ! ih i f
If inflation rates in the USA and UK are 4% and 7% respectively, then Fisher effect states that nominal interest rate in UK should be 3% higher then USA.
.
Fisher Effect«.cont
In conclusion International fisher effect states that higher interest rate in the home country will lead depreciation in the value of the home country, on the other hand a lower interest rate in the home country will lead appreciation in the value of the home currency. This relationship can be shown in the following equation and diagram.
et !
1 I f 1 Ih
1
Fisher Effect«.cont
Appreciation/Depreciation of home currency
4 3 2 1 A
1% 2% 3%
Parity Line B
-5%
-4%
-3%
-2%
-1%
4%
5%
-1 C -2 -3 -4
Interest rate differential in favour of home country
Fisher Effect«.cont
At point A, interest rate differential is 1% in favour of home country, it will lead 1% market appreciation of the home currency. At point C interest rate differential is -2%, it means home interest rate is 2% more than the interest rate of foreign country. As a result the home currency will depreciate by 2%.
IFE«example
For example if interest rate in USA is 5%, and it is 10% in UK. The spot exchange rate is USD1.6/BP 1. Then the future spot exchange rate between the two currencies will be:
et !
1 0.05 1 ! 0.045 or 4.5% 1 0.10
It means the BP will depreciate by 4.5%. In other words, USD 1.6/1.045 or USD 1.53/BP So, the exchange rate between USD and BP will be USD1.53/BP.
IFE«example
For example if interest rate in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. Then the one year forward rate between the two currencies will be:
et ! 1 0.05 1 ! 0.0194 or 1.94% 1 0.03
It means the SFr will appreciate by 1.94%. In other words, USD 0.75/0.986 or USD 0.760/SFr So, the exchange rate between USD and SFr will be USD0.760/SFr.
IFE«example
For example if interest in USA is 5%, and it is 3% in Switzerland. The spot exchange rate is USD0.75/SFr 1. What will be 90 forward rate between the two currencies will be: 3 month interest in US will be = 5*3/12=1.25% 3 month interest in Switzerland = 3*3/12=0.75%
et ! 1 0.0125 1 ! 0.0050 or 0.50% 1 0.0075
It means the SFr will appreciate by 0.50%. 90 days forward rate will be USD 0.75/0.995 or USD 0.753/SFr So, the 90 days forward rate will be USD 0.753/SFr.
Interest Rate Parity Theory
According to IRP theory spot and forward rates are closely related to each other and it is the interest rate differential between the two currencies which creates the opportunities for arbitrage. In other words interest rate differential should be equal to the forward rate differential. Interest rate parity ensures that the return on a hedged (covered) foreign investment will just equal the domestic interest rate on investment of identical risk. When this condition holds the covered interest rate differential will be zero.
Interest Rate Parity Theory«.cont
The covered interest arbitrage relationship can be explained as follow: Let eo is current spot rate, et is forward rate, if rh and rf is prevailing interest rate in New York and London respectively, then one dollar invested today in NY will yield 1+rh at the year end. The same dollar invested in London will be worth (1+rf)et/eo. Now Funds will flow from New York to London, if following situation happens: e 1 rh (1 rf ) t e0 Now Funds will flow from London to NY, if following situation happens: et 1 rh " (1 r f ) e0
Covered Interest Arbitrage
The interest rate on pound is 12% in London, and 7% on USD in New York on comparable investment. The pound spot rate is $1.75 and the one year forward rate is $1.68.
1.68 1.75
1 0.12 (1 0.07)
1.12 1.02
It means funds will flow from New York to London.
Borrow USD10,00,000 in New York at an interest rate of 7%.This means at the year end arbitrager will have to repay USD10,70,000. Convert the USD 10,00,000 to pound at the spot rate $1.75 for pound 571428.57 (10,00,000/1.75). Invest pound 571428.57 at 12% for one year in London which will yield pound 640000 to arbitrageur after one year. Simultaneously sell pound 640000 one year forward contract at a rate of $1.68, which will yield USD10,75,200. Net profit=10,75,200-10,70,000=USD 5200.
IRP and Covered Interest Arbitrage
The interest rate on USD is 8% per annum in New York and 6% per annum on euro in London. The current spot rate is euro1.13110/USD1, and the 90 days forward rate is euro1.12556/USD1. Show the covered interest arbitrage regardless of currency choice of the investor?
Investor starts with $ 10,00,000 in New York. He will convert $10,00,000 to euro at euro1.13110/USD1 for euro11,13,100 (10,00,000*1.13110) in London. He will invest euro 11,13,100 at 1.5% for 90 days, yielding him euro 11,48,066.50. Simultaneously with euro investment, sell the euro 11,48,065.50 forward contract at rate of euro1.12556/USD1 for delivery in 90days, and receive $10,20,000 Net profit $10,00,000-$10,20,000=$20,000
Covered Interest Arbitrage with transaction cost
International Exposure
Foreign Exchange Risk refers to which a company is affected by changing in exchange rates. A large number of factors affects the exchange rate between home currency and host currency which in turn affect the market value of the company.
International Exposure
Translation Exposure or Accounting ExposureChanges in income statement items and the book value of balance sheet assets and liabilities that are caused by an exchange rate change.
Operating ExposureChanges in operating cash flows caused by an exchange rate change.
Transaction ExposureChanges in the value of outstanding foreign currency denominated contracts.
Operating and Transaction exposure combined together is also called economic exposure.
Currency Translation Method
Companies with international operations will have foreign currency denominated assets and liabilities, revenues and expenses. However, they have to assigned home currency values to all the foreign currency denominated assets and liabilities, revenues and expenses. In other words, financial statements of an MNCs subsidiary must be translated from host currency to home currency before consolidated with the parent co. financial statements.
Methods of Translation or Accounting Exposure
Methods of Translation or Accounting Exposure«cont
Current/Non Current Method? With this method, all the foreign subsidiary¶s current assets and liabilities are translated into home currency at the current exchange rate. Each non current assets and liabilities are translated into home currency at its historical exchange rate-that is at the rate when these assets/liabilities acquired. ? The income statement is translated at the average exchange rate of the period except for those revenues and expenses items associated with non current assets or liabilities.
Methods of Translation or Accounting Exposure«cont
Monetary/Non Monetary Method? This method differentiates between monetary assets and liabilities- that is those items that represents a claim to receive or an obligation to pay a fixed amount of foreign currency units-and non monetary or physical assets and liabilities. Monetary assets/liabilities are translated at the current rate and non monetary assets/liabilities for example inventory, fixed assets and long term investment are translated at historical rate. ? Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to non monetary assets and liabilities.
Methods of Translation or Accounting Exposure«cont
Temporal Method? It is similar to monetary/non monetary method. The only difference is that monetary/non monetary method; inventory is translated at historical rate. Whereas in Temporal method inventory is translated at current rate if the inventory is shown on the balance sheet at market value.
Current Rate Method? All balance sheet items and income statement items are translated at the current rate.
After devaluation LC5/$1 LC LC4/$1 Monetary/ Nonmonetary Assets Cash Inventory Prepaid expenses Total current Assets Fixed Assets Accumulated depreciation Goodwill Total Assets Liabilities Current Liabilities Long term debt Deferred income tax Total Liabilities Capital Stock Retained earnings Total equity Total equity+Total liabilities Translation gain/loss 3400 3000 500 6900 1500 2600 4100 11000 850 750 125 1725 375 650 1025 2750 680 600 100 1380 375 865 1240 2620 215 680 600 100 1380 375 685 1060 2440 35 680 750 125 1555 375 500 875 2430 -150 680 600 100 1380 375 445 820 2200 -205 3600 1000 11000 900 250 2750 900 250 2620 900 250 2440 900 250 2430 720 200 2200 2600 3600 200 6400 650 900 50 1600 520 900 50 1470 520 720 50 1290 520 720 40 1280 520 720 40 1280 Temporal Current/ Noncurrent Current rates
How to manage Translation Exposure ?
1.Fund adjustment
Fund adjustment involves the altering the amounts or the currencies of the planned cash flows of parent or its subsidiaries to reduce the firm local currencies exposure. If an local currency depreciation/devaluation is expected, fund adjustment methods include pricing exports in hard currencies and imports in the local currencies, investing in hard currency securities and replacing the hard currency borrowings into local currency borrowings.
How to manage Translation Exposure ?...cont
2. Forward/Options Market Hedge? Micro Soft USA has the currency exposure of INR and Indian Companies have the exposure of US dollar. To hedge their situations Micro Soft USA would like to purchase a put/call option over INR to limit its downside/Upside risk. On the contrary, Indian Companies would like to purchase call/Put option over dollar to limit their upward/upside risk.
How to manage Translation Exposure ?...cont
3. Selecting Convenient Currency
Selecting less risky currencies for invoicing exports and imports and adjusting transfer prices are also the good techniques to reduce the translation exposure.
4. Exposure nettingThis techniques is based on cross hedging. It techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.
Statement of Financial Accounting Standards No 52 (FASB-52)
The current translation, Statement of Financial Accounting Standards No. 52 (FASB-52) was adopted in 1981. As per FASB-52, firms must use the current rate method to translate foreign currency denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items are recognized or at appropriate weighted average exchange rate for the period.
Statement of Financial Accounting Standards No 52 (FASB-52)
FASB-52 differentiates between functional currency and reporting currency. A functional currency is that one in which subsidies reports income and expenses. For example Pepsi India reporting its income and expenses in INR in India, so the functional currency is the INR. The reporting currency is the currency in which the parent co. prepares its financial statement. FASB-52 requires that the financial statement of a foreign unit first be stated in the functional currency using generally accepted accounting principles and then in reporting currency.
Managing Operating Exposure
Currency risk affects all facets of a company operations, it should not be the concern of financial manager alone. Operation manager should develop marketing and production strategy to minimize the impact of host currency risk.
Managing Operating Exposure«cont
Marketing Management of Exchange Risk
Marketing strategy calls designing the marketing strategy to minimizing the currency risk.
1.Market SelectionMNC should select that market whose currency is not so sensitive to global economic and non economic shocks.
2. Pricing StrategyCo should keep the price of its product less where the currency is very soft. On the other hand, co. should keep the price high very currency is hard.
Managing Operating Exposure«cont
3. Product StrategyCompanies often respond to exchange risk by altering their product strategy, which deals with such areas as new product introduction, product line decisions, and product innovation.
Managing Operating Exposure«cont
Production Management of Exchange Risk
MNC can manage the currency risk by working on product sourcing and plant location.
1.Input MixMNC can outsource the inputs from the countries where value of the currency is low and sell the final product to the countries where the value of the currency is high.
Managing Operating Exposure«cont
2.Shifting the Production among the PlantsMNCs can relocate their production among their plants in line with the changing dollar costs of production, increasing the production in a nation whose currency has devaluated and decreasing the production in the nation whose currency has been revaluated.
3. Plant locationShifting the plant to the countries where currency is hard.
Managing Operating Exposure«cont
Finance Strategy1. Company should purchase call option if company has payables. 2. Company should purchase put options if company has receivables.
Techniques to Manage the Transactions Exposure
If an MNC decides to hedge part or whole of all its transaction exposure, it may select from the following techniques:
1. 2. 3. 4. Futures hedge Forward hedge Money market hedge Currency Options
Future Hedge
Currency futures can be used by firms that desire to hedge transaction exposure. Purchasing currency future A firm which has to make some payments in the future date in foreign currency can purchase future contract on that currency from the future market. By purchasing the future contract on foreign currency, it locks in the amount of foreign currency needed to make the payment. Selling currency future A firm which is expected to receive payment in foreign currency is facing downside risk. Firm can sell future contract in the market over the currency which is expected to receive.
Forward Hedge
If the parent co. has the receivable than co. can take short position over the forward/future contract. On the other hand if the co. has payable than co. can take long position over the contract covering the underlying currency. Calculating the Real Cost of Hedge:
A forward hedge will be more costly than the no hedge can be estimated by calculating the real cost of hedging payables (RCH). The RCH measures the additional expenses beyond those incurred without hedging. RCH=NCH-NC
Expected value of RCH .P ! § Pi .RCH i
Where, NCH is nominal cost of hedging payables, NC is nominal cost of payables without hedging.
Forward Hedge«example
Durham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. What is the real cost of hedging is spot rate of BP is either at $1.38 or $1.42 after 90 days? Real cost of hedging when exchange rate $1.38: NCH = BP1,00,000x$1.40=$1,40,000 NC = BP1.00,000x$1.38=$1,38,000 RCH = $1,40,000-$1,38,000=$2000 Real cost of hedging when exchange rate $1.42: NCH = BP1,00,000x$1.40=$1,40,000 NC = BP1.00,000x$1.42=$1,42,000 RCH = $1,40,000-$1,42,000=-$2000 The real cost of hedging is more favorable, when real cost of hedging is negative.
Forward Hedge«example
Durham Co. will need BP1,00,000 in 90 days for British imports. Today 90 days forward rate of the BP is $1.40. what will be the expected value of the real cost hedge if following spot rates exists in next 90 days ? Spot ex. Rates $1.38 1.32 1.43 1.36 1.38 1.40 1.42 1.45
Probability Spot rate 1.3 1.32 1.34 1.36 1.38 1.4 1.42 1.45 5% 10% 15% NCH.P $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 $1,40,000 20% 20% NC.P $1,30,000 $1,32,000 $1,34,000 $1,36,000 $1,38,000 $1,40,000 $1,42,000 $1,42,000 15% 10% RCH.P $10,000 $8,000 $6,000 $4,000 $2,000 $0 ($2,000) ($5,000) 5% probability 5% 10% 15% 20% 20% 15% 10% 5%
Forward Hedge«example
The expected value of the real cost of hedging can be measured as follow:
Expected value of RCH .P ! § Pi .RCH i
E(RCH)= 0.05($10000)+0.10($8000)+0.15($6000)+0.20($4000)+0.20( 2000)+0.15(0)+0.10(-$2000)+0.05(-$5000) =$2,950
Money market Hedge
A money market hedge involves taking money market position to cover a future payables or receivables position. Money Market hedge on Payables: If a firm has excess cash, it can create a short term cash deposit in the foreign currency that will be need in the future.
Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The exchange rate between USD and NZD is USD0.65/NZD1. How much USD will be need to have NZ$1000000 after one month?
Money market Hedge
Amount need today to have NZD1000000=1000000/1+0.005=NZD995025 If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month.
lets assume Microsoft does not have excess cash. So it can borrow from bank and can create cash deposits in host county.
Example-Micro soft Inc needs NZ$10,00,000 in New Zealand in after 30 days. Banks in New Zealand are offering 6% annual (0.5% monthly) interest rate. The interest rate in US is 8.4% annual (0.7% monthly). The exchange rate between USD and NZD is USD0.65/NZD1. Now much USD will be need to have NZ$1000000 after one month?
Money market Hedge
Amount need today to have NZD1000000=1000000/1+0.005=NZD995025 If exchange rate USD0.65/NZD1, then USD needed= 995025x0.65=646766. It means Microsoft needs today USD646766 have NZD 1000000 after one month. Microsoft can borrow this amount at 0.7% monthly interest rate today after one month will pay principal amount and interest= 646766x1.007=USD651293.
Money market Hedge
Money Market hedge on Receivables: If firm expects cash receivables in a foreign currency, it can hedge this position by borrowing the currency now and converting it to dollar. This receivables can be used to set off the loan.
Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. The exchange rate between USD and SD is SD0.80/USD1. how much USD Bakersfield can have to set off the loan?
Money market Hedge
SD which can be borrowed SD400000=400000/1+0.02=SD392157 Bakersfield will borrow SD392157 today will covert it into USD. If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25 to set off some loan.
lets assume Microsoft does not have to set off any loan. Then Bakersfield can invest this amount in US securities.
Example-Bakersfield Co. is US firm that exports goods to Singapore and expects to receive SD 400000 in 90 days. The annualized interest rate in US is 8% (2% on 90days) over the amount of Singapore dollars to be borrowed to hedge the future receivables. . The US banks offering 12% annual (2% 90days) interest rate. The exchange rate between USD and SD is SD0.80/USD1. how Bakersfield will have after 90 days?
Money market Hedge
SD which can be borrowed SD400000=400000/1+0.02=SD392157 Bakersfield will borrow SD392157 today will covert it into USD. If exchange rate SD0.80/USD1, company will have USD =USD490196.25. it means if Bakersfield have SD 400000 receivable, it can create money market hedge and can use USD 490196.25. Now USD 490196.25 can be invested for 90 days at 2% 90days interest rate, and Bakersfield will have 490196.25x1.02=USD500000.18.
Options Hedge
Options HedgeIf the parent co. has the receivable than co. can purchase put option over the underlying currency. On the other hand if the co. has payable than co. can purchase call option over the underlying currency.
Some Alternative techniques of management of Transaction Exposure
Risk Shifting
Risk shifting does not reduce the currency risk, but it shift currency risk exposure from one co. to another by invoicing the payments in convenience currency or home currency. For example if Pepsi (USA) accept all its receivables from Pepsi (India), it means Pepsi (USA) has shifted dollar exposure to Pepsi (India).
Some Alternative techniques of management of Transaction Exposure
Exposure nettingIt techniques involves offsetting exposure in one currency with exposure in the another currency such that loss from host currency can be off setted by gain from another currency.
Cross hedgingWhen derivative contracts are not availabe over some particular currency, but a company has exposure in that currency, then co. hedge its exposure through by purchasing derivative contracts over some another currency, this process is called cross hedging.
Some Alternative techniques of management of Transaction Exposure
Currency risk sharingCurrency risk sharing can be implemented by developing a customized hedge contract embedded in the underlying trade transactions. The hedge contract takes the form of a price adjustment., whereby a base price is adjusted to reflect certain exchange rate changes. For example, the base price is $10m, but trading parties would share the currency risk beyond a neutral zone. The neutral zone represents the currency range in which risk is not shared.
Economic Exposure
Economic exposure is based on the extent to which the value of the firm as measured by the present value of its expected future cash flows, will change with the fluctuations in the exchange rate. Economic exposure can be separated into two components-transaction exposure and operating exposure.
Management of Economic Exposure
Techniques of management of economic exposure:
1. 2. 3. 4. 5. Option market hedge Future market hedge Forward market hedge Selection of convenient currency Selection of some hard market where value of the currency of that country does not change much.
Economic exposure..example
The revenue and cost information of XYZ ltd is given as follow.
C$=%0.75 USA (in $) Sale Cost of good sold Operating expenses US: Fixed op Variable Interest expenses C$=$0.80 C$=$0.85 Canada(in Canada(in Canada(in USA (in $) USA (in $) C$) C$) C$) 300 4 304 4 307 4 50 200 50 200 50 200 30 10% of total sale 3 30 10% of total sale 0 10 3 0 0 30 10% of total sale 3 0
10
10
Q. How the cost and revenue and earning of XYZ will change under three different exchange rates scenarios?
Economic exposure..example
Canada business is translated into the US dollar the consolidated balance sheet of the XYZ ltd ltd will be under the three exchange rate scenarios.
C$=$0.75 Sale US Canada(inUS$) Total Cost of Good sold US Canada(inUS$) Total Gross Profit Operating expenses US: Fixed US: variable 10% of total sale Total EBIT Interest expenses US Canada(inUS$) Total EBT 50 150 200 103 30 30.3 60.3 42.7 3 7.5 10.5 32.2 50 160 210 97.2 30 30.72 60.72 36.48 3 8 11 25.48 50 170 220 90.4 30 31.04 61.04 29.36 3 8.5 11.5 17.86 300 3 303 304 3.2 307.2 307 3.4 310.4 C$=$0.80 C$=$0.85
Note: Variable expenses-0.10*303=30.3 0.10*307.2=30.72 0.10*310.4=31.04
Economic exposure..example
The revenue and cost information of ABC ltd is given as follow. US (in US $) Newzealand (in NZ$) Sale 800 800 Cost of good sold 500 100 gross profit 300 700 Operating expenses 300 0 EBIT 0 700 Interest expenses 100 0 EBT -100 700
Q. How the cost and revenue and earning of ABC will change under three different exchange rates scenarios- (1) NZ$=$0.50, (2) NZ $=$0.55, (3) NZ$=$0.60?
Economic exposure..example
When Newzealand business is translated into the US dollar the consolidated balance sheet of the ABC ltd will be under the three exchange rate scenarios.
NZ$=$0.50 Sale US (in US$) Newzealand (in US$) Total Sale Cost of good sold US (in US$) Newzealand (in US$) Total cost of good sold gross profit (sale-cost of good sold) Operating expenses US (in US$) Newzealand (in US$) Total operating expenses EBIT (gross profit-op exp) Interest expenses US (in US$) Newzealand (in US$) EBT (EBIT-int exp) 800 400 1200 500 50 550 650 300 0 300 350 100 0 250 800 440 1240 500 55 555 685 300 0 300 385 100 0 285 800 480 1280 500 60 560 720 300 0 300 420 100 0 320 NZ$=$0.55 NZ$=$0.60
Investing in International Market-Euro market
Benefits of International Investing In comparison to investment in domestic market, there are number of advantages of investment in international market.
?International Diversification
Diversification is process, where funds are not invested in one security or one market, rather funds are widely diversified among securities and different markets. Through diversification a fund manager can reduce the overall risk of the portfolio.
Benefits of International Investing
International beta is used to measure the risk of a country and on the basis of beta value risk of international portfolio is diversified. Foreign Market beta value is calculated in the following way:
S tan dard deviation of Foreign Market Correlation with US stock Market v S tan dard deviation of USmarket
Benefits of International Investing
?High Rate of Returns in Emerging Markets
Emerging markets are offering high returns in comparison to developed stock markets. The fund mangers can take the advantage of investment in these markets. ?Tax Advantages Investment in some stock market is not subject to tax, so fund managers are taking the advantage of tax in investing in these stock markets.
Euro Market
Euro market refers raising capital from international market by issuing the financial securities denominated in the foreign currencies. These financial securities which are denominated in the foreign currency are commonly called euro issue. Some of the euro issues are: ? ADR (American Depository Receipt) ? European Depository Receipt) ? Global Depository Receipt) ? Indian Depository Receipt) ? FCCB (Foreign currency convertible bonds) ? Sub Account ? Participatory notes
International Bond Investing
Bonds are a debt instrument which are issued for a certain period of time and promises to give fixed yield. The benefits of international diversification extend to bond portfolios as well. In international market mainly two types of bonds are available. 1.Foreign Bond2. Euro Bond-
1. Bonds in International MarketI. Foreign BondsInfosys Tec. (Foreign Co.) US Dollar denominated Bonds
Foreign Bonds
US Market (Investors)
A bond that is issued in a domestic market by a foreign entity, in the domestic market's currency. Foreign bonds are regulated by the domestic market authorities. Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure.
2. Euro BondsInfosys Tec. (Foreign Co.) Yen denominated Bonds US Market (Investors)
Euro Bonds
A bond issued in a currency other than the currency of the country or market in which it is issued. Usually, a euro bond is issued by an international syndicate and categorized according to the currency in which it is denominated. A euro dollar bond that is denominated in U.S. dollars and issued in Japan by an Australian company would be an example of a euro bond. The Australian company in this example could issue the euro dollar bond in any country other than the U.S.
American Depository Receipt
If a foreign firm plans to issue its common equity shares in US market, it can issue through ADR in US capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in US market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the US market.
American Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
US Market
NYSE
International Bank
Re/$ Dividends in US Dollar
Depositories
US Investors
Europe Depository Receipt
If a foreign firm plans to issue its common equity shares in Europe, it can issue through EDR in European capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in Europe market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the European market.
European Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
London Market
London St. Mkt
International Bank
Re/£ Dividends in pounds
Depositories
U.K. Investors
Global Depository Receipt
If a foreign firm plans to issue its common equity shares in global market , it can issue through GDR in global capital market. The foreign firm will issue its share to some international bank which will in turn covert the equity shares into certain number of depositories. For example XYZ Inc. plans to issue one lakh shares in global market. Bank convert these shares into depository where one depository will represents certain number of shares for example one depository equal to 1000 shares. It means banks will be able to issue 100 depositories in the global market.
Global Depository Receipt
Infosysis Co. (Foreign Co.)
Equity Shares Dividends in Re.
X Market
X Mkt
International Bank
Re/X Dividends in pounds
Depositories
XY Investors
Participatory Notes
Participatory notes are issued by listed stock brokers to those investors or other brokers which are not listed with any particular stock market but they want to invest in that stock market. If some stock broker is listed with any stock market, that stock broker is bound to make all disclose to the regulatory authority of the stock market regarding the income source of their clients. If any investor or stock broker does not want to disclose its source of income they can invest through the participatory notes.
Foreign Currency Convertible Bonds
Foreign currency convertible bonds are issued by domestic firms in the international market in some foreign currency. FCCB are convertible bonds and issued with this option that on the maturity the bonds will be converted into common equity shares .
Sub Accounts
Generally big brokers are listed with the stock market so they have the main account with the stock market and they have to do trading as per rules and regulation of the stock market. To prevent any kind of default possibilities they have to put margin money as security with the regulator of the stock market. Sub account are offered by listed brokers to small brokers which are not directly listed with the stock market.
Offshore bonds
An offshore bond is a tax efficient wrapper that can hold a variety of assets like stocks and shares or mutual funds. This is a bond that adds the legal and tax shield of a life insurance policy to an investment portfolio. It is structured to simply combine a life insurance policy and a portfolio to create a wrapper that investors can buy, manage and sell their assets through. The british (or onshore) equivalent is called an µopen ended investment company¶ (oeic). Although many oeics are shared, some are private to an individual and thus a good comparison to offshore portfolio bonds.
Offshore bonds«cont
The specific benefits of investing in offshore bonds depend upon your individual circumstances. The investment funds held within offshore bonds grow free of year-on-year taxation, unlike comparable OEICs, which are taxed annually on capital growth. You won't be liable for capital gains tax when you sell a profitable fund to purchase another fund within your offshore portfolio bond. If you made the same switches within an oeic, or your equity or unit trust investments outside a portfolio bond, you may be liable for capital gains tax. This is one way that offshore bonds are often a more taxefficient way for you to invest. Offshore bonds offer regular withdrawals, that give you access to your capital in the most tax-efficient way by withdrawing up to five percent of each investment amount every year as tax-deferred 'income'.
Portfolio Risk and Return
Portfolio is combination of different types of securities. Portfolio Return
Portfolio return is the weighted average return of individual securities in the portfolio, symbolically which can be written as:
N
R p ! § wi Ri
i !1
Where, Rp is portfolio return, wi is weightage given to each security, Ri is individual security return.
Portfolio Risk and Return
Portfolio Risk
Portfolio risk is the weighted average risk of individual securities risk in the portfolio.
N
W p ! § wiW i
i !1
Where, W p is portfolio risk, wi is weightage given to each security, W i is individual security risk.
Portfolio Risk and Return in two securities case
Wipro Return Risk (SD) Investment Weight Portfolio Return Portfolio Risk 4% 2 20000 (2000/7000)=0.29 Infosys 6% 4 50000 (50000/70000)=0.71
R(wipro)*w+R(Infosys)*w 4*0.29+6*0.71=5.42% SD(wipro)*w+SD(infosys)*w 2*0.29+4*0.71=3.42
Return of this portfolio is 5.42 percent and risk is 3.42.
Portfolio Return and Risk in more than two securities case
Total Investment 1,00,000 Wipro Return Risk (SD) Investment Weight Portfolio Return Portfolio Risk 2% 2 10000 0.10 Infosys 3% 4 20000 0.20 ABB 2% 3 25000 0.25 TCS 5% 2 25000 0.25 SBI 6% 3 20000 0.20
2*0.10+3*0.20+2*0.25+5*0.25+6*0.20=3.75% 2*0.10+4*0.20+3*0.25+2*0.25+3*0.20=2.85
Return of this portfolio is 3.75 percent and risk is 2.85.
Optimal International Allocation
Optimal international allocation refers how much money should be invested in which security. The modern portfolio theory states that allocation of funds into different securities depend upon the risk-return trade off of the investors. To earn high returns, investor will have to invest in high risky portfolios. The modern portfolio theory calls it efficient market frontier, which states the relationship between risk and return in efficient capital market.
Effect of diversification on portfolio risk
Diversification is a process which includes putting more and more security in the portfolio and thereby reduction of portfolio risk. It can be shown in the figure-
Portfolio Return and Risk
Total Fund=$1,00,000 Stock-1 Return 2% Risk (Stdev) 2 Money Invested 10,000 Portfolio Return= 0.10*2 + Stock-2 3% 4 20,000 0.20*3 + Stock-3 2% 3 25,000 Stock-4 5% 2 25,000 Stock-5 6% 3 20,000 + 0.20*6 =3.75% +0.20*3 = 2.85%
0.25*2 + 0.25*5
Portfolio Risk= 0.10*2
+
0.20*4
+ 0.25*3 + 0.25*2
International Portfolio Return and Risk When portfolio also consists risk free securities Total Investment Rs 200000
1. Risky Securities
? ? ? ? ? 1. Equities 2. International Bonds 3. Mutual Funds 4. Derivatives 1. Govt. Bonds 2. Treasury Bills 3. Bank deposits Return 6% 2% 3% 4% 3% 2% 2% Risk ( ) 4% 2% 3% 2% Invest. W 10000 0.050 15000 0.075 25000 0.125 50000 0.250 25000 25000 50000 0.125 0.125 0.250
2. Risk Free Securities
? ?
Port. Ret = 6x0.050+2x0.075+3x0.125+4x0.250+3x0.125+2x0.125+2x0.250=2.95% Port. St.dev = 4x0.050+2x0.075+3x0.125+2x0.250=1.22
Country Risk Analysis
Country risk analysis is the potential risk and reward associated with making investments and doing business in a country. Country risk is bigger concept than the political risk. Country risk includes any kind of threats prevailing in the country. It can be economic threats, national security threats, political threats etc.
Political Risk in Foreign Investment
Foreign investment is very sensitive to the potential political risks of foreign exchange control and expropriation. Political risk can influence the investment in foreign market in terms of: 1.Blocked fund
Blocked fund is a situation when the govt. of the host country put control over the convertibility of host currency into foreign currency and transfer of foreign currency out of host country.
2. Expropriation
Expropriation is a situation when host govt. may reduce or eliminate ownership or control over some project in the foreign country. Expropriation is some process of doing nationalization of project.
Measuring Political Risk
Impact of political risk can not be quantified however by analyzing some factors the impact of political risk can be gauged. These factors are: 1. Political stability 2. Economic stability 3. Attitude of govt. towards foreign capital 4. Subjective factors
I. Political risk and uncertain property rights-If govt. is entitled to acquire any private property and nationalize it, it means political risk is there in that country. II. Capital flight-capital flight refers to the export of savings by a nation¶s citizens because of fears about the safety of their capital. If capital flight situation is there in any country, it means political risk is there in that country.
Economic and Political Factors Underlying the country risk
1.Fiscal irresponsibilityFiscal refers irresponsibility imposing high taxes on the corporate and individuals. 2. Monetary irresponsibilitymonetary irresponsibility refers high interest rates, and inflation in the economy. 3. Controlled exchange ratewhen the govt. has control over the exchange rate instead of having market determined rates. 4. Wasteful govt. spending 5. Resource base of the country 6. market oriented versus static policies
Financing Foreign Trade
Financing of foreign trade refers the methods of payment of exported goods.
Payment Methods for International Trade
Letters of credit (L/C)
? These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents. ? Time of payment : When shipment is made ? Goods available to buyers : After payment ? Risk to exporter : Very little or none ? Risk to importer : Relies on exporter to ship goods as described in documents
Trade Finance Methods
Letters of Credit (L/C)
± These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents. ± The importer pays the issuing bank the amount of the L/C plus associated fees. ± Commercial or import/export L/Cs are usually irrevocable.
Payment Methods for International Trade
Open Accounts
? The exporter ships the merchandise and expects the buyer to remit payment according to the agreed-upon terms. ? Time of payment : As agreed upon ? Goods available to buyers : Before payment ? Risk to exporter : Relies completely on buyer to pay account as agreed upon ? Risk to importer : None
Documents in International Trade
The following documents are need in international trade.
Bill of Lading
It is a contract between the carrier and exporter in which the carriers agrees to carry the goods from port of shipment to port of destination. Bill of lading includes±Details of merchandise ±Details of exporter and importer ±Details of mark on the merchandise ±Date of shipment ±Date of delivery ±Details of freight charges and other charges. ±Details of the liability of carrier.
Documents in International Trade
3. Insurance Certificate All cargoes going to abroad are insured. The policy of insurance covers all shipments made by the exporters. 4. Consular certificate Exports to many countries requires a special consular invoice. This invoice which varies the details and information requirements from nation to nation.
International Cash Management
Cash management is process which involves keeping the optimum level of cash at some point of time and investing the excess cash in different short term securities. Cash management involves the followings:
International Cash Management
1. 2. 3. 4. Collection and disbursement of funds Netting of interaffiliate payments Investment of excess cash. Establishment of an optimal level of worldwide corporate cash balances. 5. Cash planning and budgeting. 6. Bank relations.
Collection and disbursement of funds
Procedures for expediting Receipt of Payments.
1.Cable Remittances 2.Mobilization centers 3.Lock Boxes 4.Electronic fund transfer
Procedures for expediting Receipt of Payments.
1.Cash remittances 2.Establishing a/c in customers bank. 3.Negotiating with banks on value dating.
Netting of interaffiliate payments
Netting of interaffiliate payments is the process wherein the netting of the cash is done among the subsidiaries of the same parent company.
Payments flows before Multilateral /Bilateral netting
$20,00,000 Dutch Affiliate $70,00,000 Swedish Affiliate
$30,00,000
$80,00,000 $20,00,000 $20,00,000
$60,00,000
$50,00,000
French Affiliate
Belgian Affiliate
Payments flows after Multilateral/Bilateral netting
Paying Affiliates Receiving Affiliate Netherlands France Sweden Belgium Total Payments Netherlands France Sweden Belgium Total Receipt Net Receipt/Payment
x 6 2 1 9
8 x 0 2 10
7 4 x 5 16
4 2 3 x 9
19 12 5 8 44
10 2 -11 -1
Dutch Affiliate
$90,00,000
Swedish Affiliate
French Affiliate
Belgian Affiliate
Pooling in Multilateral Netting
Multilateral netting requires a central controlled point that can collect and record detailed information on the intra corporate accounts of each participating affiliate at specified time interval. The control point called pooling or netting centre, is a subsidiary set up in a location with minimal exchange controls for trade transactions.
Short term Financing Options
1.Intercompany financing: Intercompany financing refers when one subsidiary provide credit to another subsidiary. 2.Local currency financing:
Local currency financing can be done in the following forms. 1. Bank Loan- Banks provide credit in the form of following forms-Term Loan, Overdraft, Discounting of bills. 2. Commercial Papers-Commercial papers are short term instruments which are used to raise capital.
3. Insurance Certificate
All cargoes going to abroad are insured. The policy of insurance covers all shipments made by the exporters.
4. Consular certificate
Exports to many countries requires a special consular invoice. This invoice which varies the details and information requirements from nation to nation.
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