International Financial Management

The Foreign Exchange Market

The foreign exchange market is the market
where the currency of one country is exchanged
for the currency of another country. Most
currency transactions are channelled through
the world-wide interbank market. Interbank
market is the wholesale market in which major
banks trade with each other.
Participants
Speculators
Arbitrageurs
Traders
Hedgers

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

$ 0.62 3.65
$ 0.17
US FF FF
DM US DM
=
The spot exchange rate is the
rate at which a currency can be
bought or sold for immediate
delivery which is within two
business days after the day of the
trade.
Bid-ask spread is the difference
between the bid and ask rates of a
currency.
The forward exchange rate is the
rate that is currently paid for the
delivery of a currency at some
future date.
The forward rate may be at a
premium or at a discount.
For a direct quote, the annualised
forward discount or premium can
be calculated as follows:


Spot rate Forward rate 360
Forward premium (discount)
Spot rate Days
(
=
(

International Parity Relationships
There are the following four international
parity relationships:
Interest rate parity (IRP)
Purchasing power parity (PPP)
Forward rates and future spot rates parity
International Fisher effect (IFE).

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


/
/
(1 )
(1 )
F F D
D F D
r f
r s
+
=
+
Purchasing Power Parity
In absolute terms, purchasing power parity states that
the exchange rate between the currencies of two
countries equals the ratio between the prices of goods in
these countries. Further, the exchange rate must change
to adjust to the change in the prices of goods in the two
countries. In relative terms, purchasing power states that
the exchange rate between the currencies of the two
countries will adjust to reflect changes in the inflation
rates of the two countries. In formal terms, it implies that
the expected inflation differential equals to the current
spot rate and the expected spot rate differential. Thus:
Inflation rate differential
= Current spot rate and expected spot rate differential

/
/
(1 ) ( )
(1 )
F F D
D F D
i E s
i s
+
=
+
Thailand and South
Korea are running annual
inflation rates of 5 per
cent and 7 per cent,
respectively. The current
spot exchange rate is
Won 18.50/Baht. What
should be the value of the
Thai Baht in one year?
If purchasing power parity
holds, then the expected
spot rate after one year
will be: Won18.85/Baht.

/
/
1.07 ( )

1.05 18.5
1.07
( ) 18.5 18.85
1.05
W B
W B
E s
E s
=
= =
International Fisher Effect
In formal terms, the
international Fisher
effect states that the
nominal interest rate
differential must equal to
the expected inflation rate
differential in two
countries. Thus:
Nominal interest rate
differential = Expected
inflation rate differential

(1 ) (1 )
(1 ) (1 )
F F
D D
r E i
r E i
+ +
=
+ +
Foreign Exchange Risk
Foreign exchange risk is the risk that the
domestic currency value of cash flows,
denominated in foreign currency, may change
because of the variation in the foreign exchange
rate. There would not be any foreign exchange
risk if the exchange rates were fixed. We can
distinguish between three types of foreign
exchange exposure:
Transaction exposure
Economic exposure
Translation exposure

Transaction exposure involves the possible exchange loss or gain
on existing foreign currency-denominated transactions.
Economic exposure refers to the change in the value of the firm
caused by the unexpected changes in the exchange rate. It is also
referred to as operating exposure or the long-term cash flow
exposure.
A firm is exposed to translation loss if it uses current exchange rate
to translate its assets and liabilities. There are four methods in use
in translating assets and liabilities:
Current/non-current method
Monetary/non-monetary method
Temporal method
Current rate method

International Capital Investment
Analysis
The basic principles applicable to an
international investment decision are similar
to a domestic investment decision.
The incremental cash flow of the investment
should be discounted at an opportunity cost
of capital appropriate to the risk of the
investment. The investment should be
accepted if the net present value is positive.
One factor that distinguishes the international
investment decisions from the domestic
investment decisions is that cash flows are
earned in foreign currency. This fact should
be considered while estimating the
incremental cash flows.
International Capital Investment
Analysis
Beta of a foreign investment can be
calculated by regressing the projects return
to a benchmark market index.
In fully integrated international financial
markets, both the firms and the individual
investors are free to invest anywhere in the
world. In this case, the projects cost of capital
does not depend on any country. Investors
could diversify internationally and obtain the
international diversification benefits
themselves. In this case, beta is calculated
relative the world market index.
International Capital Investment
Analysis
POLITICAL RISK OF FOREIGN INVESTMENTS
There are two ways in which a firm can handle the
political risks in the investment evaluation. The
firm may increase the cost of capital (discount
rate) to allow for the political risks or adjust the
investments cash flows to account for political
risk.
FINANCING INTERNATIONAL OPERATIONS
The most important sources of international
finance are: Eurocurrency loans, Eurobonds, and
American or Global Depository Receipts (ADRs
or GDRs).