Вы находитесь на странице: 1из 408

Multiple Choice Questions and Answers Lecture 1

With regard to corporate goals, an MNC is mostly concerned with maximizing ____, and a purely domestic
firm is mostly concerned with maximizing ____.
a. shareholder wealth; short-term earnings
b. shareholder wealth; shareholder wealth
c. short-term earnings; sales volume
d. short-term earnings; shareholder wealth

ANS: B

For the MNC, agency costs are typically:


a. non-existent.
b. larger than agency costs of a small purely domestic firm.
c. smaller than agency costs of a small purely domestic firm.
d. the same as agency costs of a small purely domestic firm.

ANS: B

Which of the following could reduce agency problems for an MNC?


a. stock options as managerial compensation.
b. hostile takeover threat.
c. investor monitoring.
d. all of the above are forms of corporate control that could reduce agency problems for an
MNC.

ANS: D

The Sarbanes-Oxley Act improves corporate governance of MNCs because it:


a. makes executives more accountable for verifying financial statements
b. eliminates stock options as a form of compensation
c. ties executive compensation to firm performance
d. places a limit on the amount of funds that managers can spend

ANS: A

Which of the following is an example of direct foreign investment?


a. exporting to a country.
b. establishing licensing arrangements in a country.
c. purchasing existing companies in a country.
d. investing directly (without brokers) in foreign stocks.

ANS: C

1
Which of the following is not a way in which agency problems can be reduced through corporate control?
a. executive compensation.
b. threat of hostile takeover.
c. acquisition of a foreign subsidiary.
d. monitoring by large shareholders.

ANS: C

International trade:
a. is a relatively conservative approach to foreign market penetration.
b. entails minimal risk.
c. does not require large amount of investment.
d. all of the above.

ANS: D

The MNC's value depends on all of the following, except:


a. MNC's required rate of return
b. Amount of MNC's cash flows in particular currency
c. The exchange rate at which cash flows are converted to dollars
d. The value of MNC depends on all of the above factors

ANS: D

Which of the following is not an example of political risk?


a. Government may impose taxes on subsidiary
b. Government may impose barriers on subsidiary
c. Consumers may boycott the MNC
d. Consumers' income levels will decrease, thus decreasing consumption.

ANS: D

Assume that Live Co. has expected cash flows of $200,000 from domestic operations, SF200,000 from Swiss
operations, and 150,000 euros from Italian operations at the end of the year. The Swiss franc's value
and euro's value are expected to be $.83 and $1.29 respectively, at the end this year. What are the
expected dollar cash flows of Live Co?
a. $200,000
b. $559,500
c. $582,500
d. $393,500

ANS: B

Saller Co. has a subsidiary in Mexico. The expected cash flows in pesos to be received in the future from this
subsidiary have not changed since last month, but the valuation of Saller Co. has declined since last
month. What could've caused this decline in value?
a. A weaker Mexican economy
b. Lower Mexican interest rates
c. Depreciation of the Mexican peso
d. Appreciation of the Mexican peso.

2
ANS: C

Agency costs faced by multinational corporations (MNCs) may be larger than those faced by purely domestic
firms because
a. Monitoring of managers located in foreign countries is more difficult.
b. Foreign subsidiary managers raised in different cultures may not follow uniform goals.
c. MNCs are relatively large.
d. All of the above
e. A and B only

ANS: D

The most risky method(s) by which firms conduct international business is (are):
a. Franchising.
b. The acquisitions of existing operations.
c. The establishment of new subsidiaries.
d. All of the above
e. B and C only

ANS: E

3
Multiple Choice Questions and Answers Lecture 2

A high home inflation rate relative to other countries would ____ the home country's current account
balance, other things equal. A high growth in the home income level relative to other countries would
____ the home country's current account balance, other things equal.
a. increase; increase
b. increase; decrease
c. decrease; decrease
d. decrease; increase
ANS: C

If a country's government imposes a tariff on imported goods, that country's current account balance will
likely ____ (assuming no retaliation by other governments).
a. decrease
b. increase
c. remain unaffected
d. either A or C are possible
ANS: B

___ purchases more U.S. exports than the other countries listed here.
a. Italy
b. Spain
c. Mexico
d. Canada
ANS: D

An increase in the current account deficit will place ____ pressure on the home currency value, other things
equal.
a. upward
b. downward
c. no
d. upward or downward (depending on the size of the deficit)
ANS: B

If the home currency begins to appreciate against other currencies, this should ____ the current account
balance, other things equal (assume that substitutes are readily available in the countries, and that the
prices charged by firms remain the same).
a. increase
b. have no impact on
c. reduce
d. all of the above are equally possible
ANS: C

1
The World Bank was established to:
a. enhance development solely in Asia through grants.
b. enhance economic development through non-subsidized loans (at market interest rates).
c. enhance economic development through low-interest rate loans (below-market rates).
d. enhance economic development of the private sector through investment in stock of
corporations.
ANS: B

The North American Free Trade Agreement (NAFTA) increased restrictions on:
a. trade between Canada and Mexico.
b. trade between Canada and the U.S.
c. direct foreign investment in Mexico by U.S. firms.
d. none of the above.
ANS: D

Over the last several years, international trade has generally:


a. increased for most major countries.
b. decreased for most major countries.
c. stayed about constant for most major countries.
d. increased for about half the major countries and decreased for the others.
ANS: A

The direct foreign investment positions by U.S. firms have generally ____ over time. Restrictions by
governments on direct foreign investment have generally ___ over time.
a. increased; increased
b. increased; decreased
c. decreased; decreased
d. decreased; increased
ANS: B

A weakening of the U.S. dollar with respect to the British pound would likely reduce the U.S. exports to
Britain and increase U.S. imports from Britain over time.
a. True
b. False

ANS: F

Assume that some U.S. firms will purchase supplies from either China or from U.S. firms. If the Chinese
yuan appreciates against the dollar, it should reduce the U.S. balance of trade deficit with China.
a. True
b. False

ANS: T

2
Which of the following statements is not true?
a. Exporters commonly complain that they are being mistreated because the currency of their
country is too weak.
b. Outsourcing affects the balance of trade because it means that a service is purchased in
another country.
c. Sometimes, trade policies are used to punish countries for various actions.
d. Tariffs imposed by the EU have caused some friction between EU countries that
commonly import products and other EU countries.
e. All of the above are true.
ANS: A

Which of the following is not a goal of the International Monetary Fund (IMF)?
a. To promote cooperation among countries on international monetary issues
b. To promote stability in exchange rates
c. To enhance a country's long-term economic growth via the extension of structural
adjustment loans
d. To promote free trade
e. To promote free mobility of capital funds across countries
ANS: C

According to the "J curve effect," a weakening of the U.S. dollar relative to its trading partners' currencies
would result in an initial ____ in the current account balance, followed by a subsequent ____ in the
current account balance.
a. decrease; increase
b. increase; decrease
c. decrease; decrease
d. increase; increase
ANS: A

The ____, an accord among 117 nations, called for lower tariffs around the world.
a. General Agreement on Tariffs and Trade (GATT)
b. North American Free Trade Agreement (NAFTA)
c. Single European Act of 1987
d. European Union Accord
e. None of the above
ANS: A

Japan's annual interest rate has been relatively ____ compared to other countries for several years, because
the supply of funds in its credit market has been very ____.
a. low; small
b. high; small
c. low; large
d. high; large
ANS: C

3
Multiple Choice Questions and Answers Lecture 3

Assume that a bank's bid rate on Japanese yen is $.0041 and its ask rate is $.0043. Its bid-
ask percentage spread is:
a. about 4.99%.
b. about 4.88%.
c. about 4.65%.
d. about 4.43%.

ANS:C

The bid/ask spread for small retail transactions is commonly in the range of ____ percent.
a. 3 to 7
b. .01 to .03
c. 10 to 15
d. .5 to 1

ANS: A

If a U.S. firm desires to avoid the risk from exchange rate fluctuations, and it will need
C$200,000 in 90 days to make payment on imports from Canada, it could:
a. obtain a 90-day forward purchase contract on Canadian dollars.
b. obtain a 90-day forward sale contract on Canadian dollars.
c. purchase Canadian dollars 90 days from now at the spot rate.
d. sell Canadian dollars 90 days from now at the spot rate.

ANS: A

Forward markets for currencies of developing countries are:


a. prohibited.
b. less liquid than markets for developed countries.
c. more liquid than markets for developed countries.
d. only available for use by government agencies.

ANS: B

1
____ is not a bank characteristic important to customers in need of foreign exchange.
a. Quote competitiveness
b. Speed of execution
c. Forecasting advice
d. Advice about current market conditions
e. All of the above are important bank characteristics to customers in need of
foreign exchange.

ANS: E

The main participants in the international money market are:


a. consumers.
b. small firms.
c. large corporations.
d. small European firms needing European currencies for international trade.

ANS: C

International money market transactions normally represent:


a. the equivalent of $1 million or more.
b. the equivalent of $1,000 to $10,000.
c. the equivalent of between $10,000 and $100,000.
d. the equivalent of between $100,000 and $200,000.

ANS: A

Futures contracts are typically ____; forward contracts are typically ____.
a. sold on an exchange; sold on an exchange
b. offered by commercial banks; sold on an exchange
c. sold on an exchange; offered by commercial banks
d. offered by commercial banks; offered by commercial banks

ANS: C

Which of the following is not true regarding the Bretton Woods Agreement?
a. It called for fixed exchange rates between currencies.
b. Governments intervened to prevent exchange rates from moving more than
1 percent above or below their initially established levels.
c. The agreement lasted from 1944 until 1971.
d. Each country used gold to back its currency.

2
e. All of the above are true regarding the Bretton Woods Agreement.

ANS: D

The ADR of a British firm is convertible into 3 shares of stock. The share price of the firm
was 30 pounds when the British market closed. When the U.S. market opens, the
pound is worth $1.63. The price of this ADR should be $____.
a. 48.90
b. 146.70
c. 55.21
d. none of the above

ANS:B

Which of the following is probably not an example of the use of forward contracts by an
MNC?
a. Hedging pound payables by selling pounds forward
b. Hedging peso receivables by selling pesos forward
c. Hedging yen payables by purchasing yen forward
d. Hedging peso payables by purchasing pesos forward
e. All of the above are examples of using forward contracts.

ANS: A

A quotation representing the value of a foreign currency in dollars is referred to as a(n)


____ quotation; a quotation representing the number of units of a foreign currency
per dollar is referred to as a(n) ____ quotation.
a. direct; indirect
b. indirect; direct
c. direct; direct
d. indirect; indirect
e. cannot be answered without more information

ANS: A

Which of the following is probably not appropriate for an MNC wishing to reduce its
exposure to British pound payables?
a. Purchase pounds forward
b. Buy a pound futures contract
c. Buy a pound put option
d. Buy a pound call option

3
ANS: C

Futures contracts are sold on exchanges and are consequently ____ than forward
contracts, which can be ____ to satisfy an MNC's needs.
a. more standardized; standardized
b. more standardized; custom-tailored
c. more custom-tailored; standardized
d. more custom-tailored; custom-tailored
e. less standardized; custom-tailored

ANS: B

An MNC's short-term financing decisions are satisfied in the ____ market, while its
medium debt financing decisions are satisfied in the ____ market.
a. international money; international credit
b. international money; international bond
c. international credit; international money
d. international bond; international credit
e. international money; international stock

ANS: A

The LIBOR varies among currencies because the market supply of and demand for funds
vary among currencies.
a. True
b. False

ANS: T

An MNC with receivables in Japanese Yen purchases yen forward to hedge its exposure to
exchange rate fluctuations.
a. True
b. False

ANS: F

A currency put option provides the right, but not the obligation, to buy a specific currency
at a specific price within a specific period of time.
a. True
b. False

ANS: F

4
Which of the following is not true regarding ADRs?
a. ADRs are denominated in the currency of the stock's home country.
b. ADRs enable U.S. investors to avoid cross-border transactions
c. ADRs allow non-U.S. firms to tap into U.S. market for funds.
d. ADRs sometimes allow for arbitrage opportunities.

ANS: A

The interest rate on the syndicated loan depends on the:


a. currency denominating the loan.
b. maturity of the loan.
c. creditworthiness of the borrower.
d. interbank lending rate.
e. all of the above.

ANS: E

When obtaining a loan, the risk premium paid above LIBOR depends on the:
a. risk-free interest rate of the borrower.
b. credit risk of the borrower.
c. borrower's stock price.
d. lender's stock price.

ANS: B

The interest rate in developing countries is usually very low.


a. True
b. False

ANS: F

An obligation to purchase a specific amount of currency at a future point in time is called a:


a. call option
b. spot contract
c. put option
d. forward contract
e. both B and D

ANS: D

5
The strike price is also known as the premium price.
a. True
b. False

ANS: F

6
Multiple Choice Questions and Answers Lecture 4

____ is not a factor that causes currency supply and demand schedules to change.
a. Relative inflation rates
b. Relative interest rates
c. Relative income levels
d. Expectations
e. All of the above are factors that cause currency supply and demand
schedules to change.

ANS: E

The exchange rates of smaller countries are very stable because the market for their
currency is very liquid.
a. True
b. False

ANS: F

The phrase "the dollar was mixed in trading" means that:


a. the dollar was strong in some periods and weak in other periods over the
last month.
b. the volume of trading was very high in some periods and low in other
periods.
c. the dollar was involved in some currency transactions, but not others.
d. the dollar strengthened against some currencies and weakened against
others.

ANS: D

Any event that reduces the U.S. demand for Japanese yen should result in a(n) ____ in the
value of the Japanese yen with respect to ____, other things being equal.
a. increase; U.S. dollar
b. increase; nondollar currencies
c. decrease; nondollar currencies
d. decrease; U.S. dollar

ANS: D

1
Any event that reduces the supply of Swiss francs to be exchanged for U.S. dollars should
result in a(n) ____ in the value of the Swiss franc with respect to ____, other things
being equal.
a. increase; U.S. dollar
b. increase; nondollar currencies
c. decrease; nondollar currencies
d. decrease; U.S. dollar

ANS: A

Which of the following is not mentioned in the text as a factor affecting exchange rates?
a. relative interest rates.
b. relative inflation rates.
c. government controls.
d. expectations.
e. all of the above are mentioned in the text as factors affecting exchange
rates.

ANS: E

When expecting a foreign currency to depreciate, a possible way to speculate on this


movement is to borrow dollars, convert the proceeds to the foreign currency, lend in
the foreign country, and use the proceeds from this investment to repay the dollar
loan.
a. True
b. False

ANS: F

Assume that the British government eliminates all controls on imports by British
companies. Other things being equal, the U.S. demand for pounds would ____, the
supply of pounds for sale would ____, and the equilibrium value of the pound would
____.
a. increase; increase; increase
b. decrease; increase; decrease
c. remain unchanged; increase; decrease
d. remain unchanged; increase; increase

ANS: C

2
Assume that U.S. inflation is expected to surge in the near future. The expectation of surge
in inflation will most likely place ____ pressure on U.S. dollar immediately.
a. upward
b. downward
c. no
d. cannot be determined

ANS: B

Which of the following interactions will likely have the least effect on the dollar's value?
Assume everything else is held constant.
a. A reduction in U.S. inflation accompanied by an increase in real U.S.
interest rates
b. A reduction in U.S. inflation accompanied by an increase in nominal U.S.
interest rates
c. An increase in U.S. inflation accompanied by an increase in nominal, but
not real, U.S. interest rates
d. An increase in Singapore's inflation accompanied by an increase in real
U.S. interest rates
e. An increase in Singapore's interest rates accompanied by an increase in
U.S. inflation.

ANS: C

Investors from Germany, the United States, and the U.K. frequently invest in each other
based on prevailing interest rates. If British interest rates increase, German investors
are likely to buy ____ dollar-denominated securities, and the euro is likely to ____
relative to the dollar.
a. fewer; depreciate
b. fewer; appreciate
c. more; depreciate
d. more; appreciate

ANS: A

If the U.S. and Japan engage in substantial financial flows but little trade, ____ directly
influences their exchange rate the most. If the U.S. and Switzerland engage in much
trade but little financial flows, ____ directly influences their exchange rate the most.
a. interest rate differentials; interest rate differentials
b. inflation and interest rate differentials; interest rate differentials
c. income and interest rate differentials; inflation differentials
d. interest rate differentials; inflation and income differentials
e. inflation and income differentials; interest rate differentials

ANS: D

3
If inflation increases substantially in Australia while U.S. inflation remains unchanged, this
is expected to place ____ pressure on the value of the Australian dollar with respect
to the U.S. dollar.
a. upward
b. downward
c. either upward or downward (depending on the degree of the increase in
Australian inflation)
d. none of the above; there will be no impact

ANS: B

Assume that British corporations begin to purchase more supplies from the U.S. as a result
of several labor strikes by British suppliers. This action reflects:
a. an increased demand for British pounds.
b. a decrease in the demand for British pounds.
c. an increase in the supply of British pounds for sale.
d. a decrease in the supply of British pounds for sale.

ANS: C

Assume that Canada places a strict quota on goods imported from the U.S. and that the
U.S. does not retaliate. Holding other factors constant, this event should immediately
cause the supply of Canadian dollars to be exchanged for U.S. dollars to ____ and
the value of the Canadian dollar to ____.
a. increase; increase
b. increase; decline
c. decline; decline
d. decline; increase

ANS: D

If a country experiences high inflation relative to the U.S., its exports to the U.S. should
____, its imports should ____, and there is ____ pressure on its currency's
equilibrium value.
a. decrease; increase; upward
b. decrease; decrease; upward
c. increase; decrease; downward
d. decrease; increase; downward
e. increase; decrease; upward

ANS: D

4
Country X frequently engages in trade flows with the U.S. (such as imports and exports).
Country Y frequently engages in capital flows with the U.S. (such as financial
investments). Everything else held constant, an increase in U.S. interest rates would
affect the exchange rate of Country X's currency more than the exchange rate of
Country Y's currency.
a. True
b. False

ANS: F

The value of euro was $1.30 last week. During last week the euro depreciated by 5%. What
is the value of euro today?
a. $1.365
b. $1.235
c. $1.330
d. $1.30

ANS:B
SOLUTION: $1.3 (1 .05) = $1.235

Assume that the income levels in U.K. start to rise, while U.S. income levels remain
unchanged. This will place ____ pressure on the value of British pound. Also,
assume that U.S. interest rates rise, while the British pound remains unchanged. This
will place ____ pressure on the value of British pound.
a. downward; downward
b. upward; downward
c. upward; upward
d. downward; upward

ANS: A

If the Fed announces that it will decrease the U.S. interest rates, and European Central
Bank takes no action, then the value of euro will ____ against the value of U.S.
dollar. The Fed's action is called ____ intervention.
a. appreciate; direct
b. depreciate; direct
c. appreciate; indirect
d. depreciate; indirect

ANS: C

5
British investors frequently invest in the U.S. or Italy, depending on the prevailing interest
rates. If Italian interest rates suddenly rise high above U.S. rates, the investors will
____ the supply of pounds to be exchanged for dollars and thus put ____ pressure
on the value of the pound against the U.S. dollar.
a. increase; downward
b. decrease; upward
c. increase; upward
d. decrease; downward

ANS: B

Illiquid currencies tend to exhibit ____ volatile exchange rate movements, as the
equilibrium prices of their currencies adjust to ____ changes in supply and demand
conditions.
a. less; even minor
b. less; only large
c. more; even minor
d. more; only large
e. none of the above

ANS: C

Which of the following events would most likely result in an appreciation of the U.S.
dollar?
a. U.S. inflation is very high.
b. The Fed indicates that it will raise U.S. interest rates.
c. Future U.S. interest rates are expected to decline.
d. Japan is expected to increase interest rates in the near future.

ANS: B

If a country experiences an increase in interest rates relative to U.S. interest rates, the
inflow of U.S. funds to purchase its securities should ____, the outflow of its funds
to purchase U.S. securities should ____, and there is ____ pressure on its
currency's equilibrium value.
a. increase; decrease; downward
b. decrease; increase; upward
c. increase; decrease; upward
d. decrease; increase; downward
e. increase; increase; upward

ANS: C

6
Multiple Choice Questions and Answers Lecture 5

Currency options sold through an options exchange:


a. contain a commitment to the owner, and are standardized.
b. contain a commitment to the owner, and can be tailored to the desire of the owner.
c. contain a right but not a commitment to the owner, and can be tailored to the desire of the
owner.
d. contain a right but not a commitment to the owner, and are standardized.
ANS: D

If you expect the British pound to appreciate, you could speculate by ____ pound call options or ____ pound
put options.
a. purchasing; selling
b. purchasing; purchasing
c. selling; selling
d. selling; purchasing
ANS: A

Research has found that the options market is:


a. efficient before controlling for transaction costs.
b. efficient after controlling for transaction costs.
c. highly inefficient.
d. none of the above
ANS: B

If the spot rate of the euro increased substantially over a one-month period, the futures price on euros would
likely ____ over that same period.
a. increase slightly
b. decrease substantially
c. increase substantially
d. stay the same
ANS: C

If you purchase a straddle on euros, this implies that you:


a. finance the purchase of a call option by selling a put option in the euros.
b. finance the purchase of a call option by selling a call option in the euros.
c. finance the purchase of a put option by selling a put option in the euros.
d. finance the purchase of a put option by selling a call option in the euros.
e. none of the above
ANS: E

1
European currency options can be exercised ____; American currency options can be exercised ____.
a. any time up to the expiration date; any time up to the expiration date
b. any time up to the expiration date; only on the expiration date
c. only on the expiration date; only on the expiration date
d. only on the expiration date; any time up to the expiration date
ANS: D

Macomb Corporation is a U.S. firm that invoices some of its exports in Japanese yen. If it expects the yen to
weaken, it could ____ to hedge the exchange rate risk on those exports.
a. sell yen put options
b. buy yen call options
c. buy futures contracts on yen
d. sell futures contracts on yen
ANS: D

Which of the following is not an instrument used by U.S.-based MNCs to cover their foreign currency
positions?
a. forward contracts.
b. futures contracts.
c. non-deliverable forward contracts.
d. options.
e. all of the above are instruments used to cover foreign currency positions.
ANS: E

When the futures price on euros is below the forward rate on euros for the same settlement date, astute
investors may attempt to simultaneously ____ euros forward and ____ euro futures.
a. sell; sell
b. buy; sell
c. sell; buy
d. buy; buy
ANS: C

Which of the following would result in a profit of a euro futures contract when the euro depreciates?
a. buy a euro futures contract; sell a futures contract after the euro has depreciated.
b. sell a euro futures contract; buy a futures contract after the euro has depreciated.
c. buy a euro futures contract; buy an additional futures contract after the euro has
depreciated.
d. none of the above would result in a profit when the euro depreciates.
ANS: B

2
Which of the following is not true regarding options?
a. Options are traded on exchanges, never over-the-counter.
b. Similar to futures contracts, margin requirements are normally imposed on option traders.
c. Although commissions for options are fixed per transaction, multiple contracts may be
involved in a transaction, thus lowering the commission per contract.
d. Currency options can be classified as either put or call options.
e. All of the above are true.
ANS: A

Which of the following are most commonly traded on an exchange?


a. forward contracts.
b. futures contracts.
c. currencies
d. none of the above
ANS: B

Which of the following is true of options?


a. The writer decides whether the option will be exercised.
b. The writer pays the buyer the option premium.
c. The buyer decides if the option will be exercised.
d. More than one of these.
ANS: C

If you have bought the right to sell, you are a:


a. call writer.
b. put buyer.
c. futures buyer.
d. put writer.
ANS: B

Which of the following is true for futures, but not for forwards?
a. actual delivery.
b. no transactions costs.
c. self regulation.
d. none of the above
ANS: D

3
Non-deliverable forward contracts (NDFs) are frequently used for currencies in emerging markets.
a. True
b. False

ANS: T

Since futures contracts are traded on an exchange, the exchange will always take the "other side" of the
transaction in terms of accepting the credit risk.
a. True
b. False

ANS: T

Due to put-call parity, we can use the same formula to price calls and puts.
a. True
b. False

ANS: F

If the futures rate is above the forward rate, actions by rational investors would put upward pressure on the
forward rate and downward pressure on the futures rate.
a. True
b. False

ANS: T

Futures contracts are standardized with respect to delivery date and the futures price specified for the
settlement date.
a. True
b. False

ANS: F

Margin requirements are deposits placed by investors in futures contracts with their respective brokerage
firms when they take their position. They are intended to minimize credit risk associated with futures
contracts.
a. True
b. False

ANS: T

4
A European option can only be exercised at the expiration date, while an American option can be exercised
any time prior to the expiration date.
a. True
b. False

ANS: T

The forward premium is the price specified in a call or put option.


a. True
b. False

ANS: F

An MNC frequently uses either forward or futures contracts to hedge its exposure to foreign receivables. To
do so, the MNC can either sell the foreign currency forward or sell futures.
a. True
b. False

ANS: T

Margin is used in the forward market to mitigate default risk.


a. True
b. False

ANS: F

There are no transactions costs associated with trading futures or options.


a. True
b. False

ANS: F

Options can be traded on an exchange or over the counter.


a. True
b. False

ANS: T

American style options can be exercised any time up to maturity.


a. True
b. False

ANS: T

5
If a currency put option is out of the money, then the present exchange rate is less than the strike price.
a. True
b. False

ANS: F

If you have a position where you might be obligated to sell pounds, you are:
a. a call writer.
b. a call buyer.
c. a put writer.
d. a put buyer.
ANS: A

A put option on Swiss franc has a strike (exercise) price of $.92. The present exchange rate is $.89. This put
option can be referred to as:
a. in the money.
b. out of the money.
c. at the money.
d. at a discount.
ANS: A

The writer of a put option has a right, but not obligation, to buy the underlying currency from the option
buyer.
a. True
b. False

ANS: F

An MNC frequently uses either forward or futures contracts to hedge its exposure to foreign payables. To do
so, the MNC can either sell the foreign currency forward or sell futures.
a. True
b. False

ANS: F

Hedgers should buy calls if they are hedging an expected outflow of foreign currency.
a. True
b. False

ANS: T

6
If a currency's forward rate exhibits a discount, the currency is forced to appreciate.
a. True
b. False

ANS: F

If a currency call option is in the money, then the present exchange rate exceeds the strike price.
a. True
b. False

ANS: T

If the forward rate for a currency is less than the spot rate for that currency, the forward rate is said to exhibit
a premium.
a. True
b. False

ANS: F

Non-deliverable forward contracts (NDFs) are frequently used for currencies in emerging markets.
a. True
b. False

ANS: T

Since corporations have specialized needs, they usually prefer futures contracts to forward contracts for
hedging purposes.
a. True
b. False

ANS: F

A speculator in futures contracts expecting the value of a foreign currency to depreciate would likely sell
futures contracts.
a. True
b. False

ANS: T

A currency call option grants the right to sell a specific currency at a designated price within a specific time
period.
a. True
b. False

7
ANS: F

Currency call options allow the purchaser to lock in the price paid for a currency. Therefore, they are often
used by MNCs to hedge foreign currency payables.
a. True
b. False

ANS: T

Both call and put option premiums are affected by the level of the existing spot price relative to the strike
price; for example, a high spot price relative to the strike price will result in a relatively high premium
for a call option but a relatively low premium for a put option.
a. True
b. False

ANS: T

The lower bound of the call option premium is the greater of zero and the difference between the spot rate
and the exercise price; the upper bound of a currency call option is the spot rate.
a. True
b. False

ANS: T

A forward rate for a currency is said to exhibit a discount if


a. the forward rate exceeds the existing spot rate.
b. the forward rate is less than the existing spot rate.
c. the forward rate exceeds the expected future spot rate.
d. the forward rate is less than the expected future spot rate.
e. none of the above
ANS: B

When the futures price is above the forward rate, astute investors may attempt to simultaneously buy a
currency forward and sell futures in that currency. These actions would place ____ pressure on the
forward rate and ____ pressure on the futures rate.
a. upward; downward
b. upward; upward
c. downward; upward
d. downward; downward
ANS: A

8
Currency futures can be used by MNCs to hedge payables. That is, an MNC would ____ futures to hedge a
foreign payable position. Also, currency futures can be used for speculation. For example, a
speculator expecting a currency to appreciate would ____ futures.
a. buy; buy
b. sell; sell
c. buy; sell
d. sell; buy
ANS: A

When the existing spot rate exceeds the exercise price, a call option is ____, and a put option is ____.
a. out of the money; in the money
b. out of the money; out of the money
c. in the money; in the money
d. in the money; out of the money
ANS: D

When a currency call option is classified as "in the money," this indicates that
a. the spot rate of the currency is less than the exercise price of the option.
b. the spot rate of the currency is greater than the exercise price of the option.
c. the buyer of the option would generate a profit; that is, the spot rate would exceed the sum
of the exercise price and the premium paid.
d. the buyer of the option would generate a profit; that is, the exercise price would exceed the
sum of the spot rate and the premium paid.
ANS: B

Which of the following is not true regarding options?


a. The buyer of a call option has the right to buy the currency at the strike price.
b. The writer of a call option has the obligation to sell the currency to the buyer if the option
if exercised.
c. The buyer of a put option has the right to sell the currency at the strike price.
d. The writer of a put option has the obligation to sell the currency to the buyer if the option
is exercised.
ANS: D

Forward contracts:
a. contain a commitment to the owner, and are standardized.
b. contain a commitment to the owner, and can be tailored to the desire of the owner.
c. contain a right but not a commitment to the owner, and can be tailored to the desire of the
owner.
d. contain a right but not a commitment to the owner, and are standardized.
ANS: B

9
A U.S. firm is bidding for a project needed by the Swiss government. The firm will not know if the bid is
accepted until three months from now. The firm will need Swiss francs to cover expenses but will be
paid by the Swiss government in dollars if it is hired for the project. The firm can best insulate itself
against exchange rate exposure by:
a. selling futures in francs.
b. buying futures in francs.
c. buying franc put options.
d. buying franc call options.
ANS: D

A firm wants to use an option to hedge 12.5 million in receivables from New Zealand firms. The premium is
$.03. The exercise price is $.55. If the option is exercised, what is the total amount of dollars received
(after accounting for the premium paid)?
a. $6,875,000.
b. $7,250,000.
c. $7,000,000.
d. $6,500,000.
e. none of the above
ANS: D
SOLUTION: Dollars received from exercising option = NZ$12.5 million $.55 =
$6,875,000. Premium paid for options = NZ$12.5 million $.03 = $375,000.
Amount of dollars received minus premium = $6,500,000.

The premium on a pound put option is $.03 per unit. The exercise price is $1.60. The break-even point is
____ for the buyer of the put, and ____ for the seller of the put. (Assume zero transactions costs and
that the buyer and seller of the put option are speculators.)
a. $1.63; $1.63
b. $1.63; $1.60
c. $1.63; $1.57
d. $1.57; $1.63
e. none of the above
ANS: E
SOLUTION: Break-even point on put option to both the buyer and seller is $1.60 $.03 =
$1.57.

The existing spot rate of the Canadian dollar is $.82. The premium on a Canadian dollar call option is $.04.
The exercise price is $.81. The option will be exercised on the expiration date if at all. If the spot rate
on the expiration date is $.87, the profit as a percent of the initial investment (the premium paid) is:
a. 0 percent.
b. 25 percent.
c. 50 percent.
d. 150 percent.
e. none of the above
ANS: C

10
SOLUTION: The net profit per unit is: $.87 $.81 $.04 = $.02. The net profit per unit as
a percent of the initial investment per unit is: $.02/$.04 = 50%.

You are a speculator who sells a call option on Swiss francs for a premium of $.06, with an exercise price of
$.64. The option will not be exercised until the expiration date, if at all. If the spot rate of the Swiss
franc is $.69 on the expiration date, your net profit per unit, assuming that you have to buy Swiss
francs in the market to fulfill your obligation, is:
a. $.02.
b. $.01.
c. $.01.
d. $.02.
e. none of the above
ANS: C
SOLUTION: Net profit per unit = $.64 + $.06 $.69 = $.01.

A call option on Australian dollars has a strike (exercise) price of $.56. The present exchange rate is $.59.
This call option can be referred to as:
a. in the money.
b. out of the money.
c. at the money.
d. at a discount.
ANS: A

A put option on British pounds has a strike (exercise) price of $1.48. The present exchange rate is $1.55. This
put option can be referred to as:
a. in the money.
b. out of the money.
c. at the money.
d. at a discount.
ANS: B

Frank is an option speculator. He anticipates the Danish kroner to appreciate from its current level of $.19 to
$.21. Currently, kroner call options are available with an exercise price of $.18 and a premium of
$.02. Should Frank attempt to buy this option? If the future spot rate of the Danish kroner is indeed
$.21, what is his profit or loss per unit?
a. no; $0.01.
b. yes; $0.01.
c. yes; $0.01.
d. yes; $0.03.
ANS: B
SOLUTION: The net profit per unit is: $.21 $.18 $.02 = $.01.

11
Johnson, Inc., a U.S.-based MNC, will need 10 million Thai baht on August 1. It is now May 1. Johnson has
negotiated a non-deliverable forward contract with its bank. The reference rate is the baht's closing
exchange rate (in $) quoted by Thailand's central bank in 90 days. The baht's spot rate today is $.02. If
the rate quoted by Thailand's central bank on August 1 is $.022, Johnson will ____ $____.
a. pay; 20,000
b. be paid; 20,000
c. pay; 2,000
d. be paid; 2,000
e. none of the above
ANS: B
SOLUTION: Amount received per unit = $.022 $.02 = $.002 THB10,000,0000 =
$20,000.

A put option premium has a lower bound that is equal to the greater of zero and the difference between the
underlying ____ prices. The upper bound of a call option premium is the ____ price.
a. spot and exercise; exercise
b. spot and exercise; spot
c. exercise and spot; exercise
d. exercise and spot; spot
ANS: C

A call option premium has a lower bound that is equal to the greater of zero and the difference between the
underlying ____ prices. The upper bound of a call option premium is the ____ price.
a. spot and exercise; exercise
b. spot and exercise; spot
c. exercise and spot; exercise
d. exercise and spot; spot
ANS: B

Assume the spot rate of a currency is $.37 and the 90-day forward rate is $.36. The forward rate of this
currency exhibits a ____ of ____ on an annualized basis.
a. discount; 11.11%
b. premium; 11.11%
c. premium; 10.81%
d. discount; 10.81%
ANS: D
SOLUTION: Discount = [(FR SR)/SR] (360/90)
= [($.36 $.37)/$.37] (360/90)
= 10.81% (Discount)

12
Which of the following is true regarding the options markets?
a. Hedgers and speculators both attempt to lower risk.
b. Hedgers attempt to lower risk, while speculators attempt to make riskless profits.
c. Hedgers and speculators are both necessary in order for the market to be liquid.
d. all of the above
ANS: C

The purchase of a currency put option would be appropriate for which of the following?
a. Investors who expect to buy a foreign bond in one month.
b. Corporations who expect to buy foreign currency to finance foreign subsidiaries.
c. Corporations who expect to collect on a foreign account receivable in one month.
d. all of the above
ANS: C

If an investor who previously sold futures contracts wishes to liquidate his position, he could sell futures
contracts with the same maturity date.
a. True
b. False

ANS: F

An option writer is the seller of a call or a put option.


a. True
b. False

ANS: T

Hedgers should buy puts if they are hedging an expected inflow of foreign currency.
a. True
b. False

ANS: T

The 180-day forward rate for the euro is $1.34, while the current spot rate of the euro is $1.29. What is the
annualized forward premium or discount of the euro?
a. 7.46% premium
b. 7.46% discount
c. 7.75% premium
d. 7.75% discount
ANS: C
SOLUTION: [(F/S) 1] 360/180 = [($1.34/$1.29) 1] 360/180 = 7.75%

13
The annualized forward premium on the euro is 7%. What is the 90-day forward rate on the euro if the spot
rate today is $1.25?
a. $1.27
b. $1.34
c. $1.16
d. $1.23
ANS: A
SOLUTION: $1.25 [1 + 7%/(360/90)] = $1.27

The premium on a euro call option is $.02. The exercise price is $1.32. The break-even point is ____
for the buyer of the call, and ____ for the seller of the call. (Assume zero transactions costs and that
the buyer and seller of the put option are speculators.)
a. $1.30; $1.30
b. $1.34; $1.30
c. $1.30; $1.34
d. $1.34; $1.34
ANS: D
SOLUTION: Break-even point on call option to both the buyer and seller is $1.32 + $.02 =
$1.34.

A call option on Japanese yen has a strike (exercise) price of $.012. The present exchange rate is $.011. This
call option can be referred to as:
a. in the money.
b. out of the money.
c. at the money.
d. at a discount.
ANS: B

J&L Co. is a U.S.-based MNC that frequently exports computers to Italy. J&L typically invoices these goods
in euros and is concerned that the euro will depreciate in the near future. Which of the following is not
an appropriate technique under these circumstances?
a. purchase euro put options.
b. sell euros forward.
c. sell euro futures contracts.
d. sell euro put options.
ANS: D

The ____ the existing spot price relative to the strike price, the ____ valuable the put options will be.
a. higher; less
b. higher; more
c. lower; less
d. lower; more
ANS: D

14
On January 1st, Madison Co. ordered raw material from Japan and agreed to pay 100 million yen for this
order on April 1st. It negotiated a 3-month forward contract to obtain 100 million Japanese yen on that
date at $.009. On February 1st, the Japanese firm informed Madison Co. that it won't be able to fulfill
that order. The Japanese yen spot rate on February 1st is $.0087 and 2-month forward rate exhibits 3%
discount. To offset its existing contract Madison Co. will negotiate a forward contract to ____ for the
date of April 1st and the profit/loss generated from this transaction is a ____ U.S. dollars.
a. sell yen; gain of $60,000
b. sell yen; loss of $60,000
c. buy yen; gain of $30,000
d. to buy yen; loss of $30,000
ANS: B
SOLUTION: 2-month forward rate = $.0087 (1 .03) = $.0084
Profit/loss from transaction = (100,000,000 $.0084) (100,000,000 .009)
= $60,000 loss.

Which of the following does not represent the risk from using forward contracts?
a. if a forward contract is used to hedge receivables, and the spot exchange rate at the
expiration of contract exceeds the contract price.
b. if a forward contract is used to hedge receivables, and the spot exchange rate at the time of
expiration of contract is lower than the contract price.
c. if a forward contract is used to hedge payables, and the spot exchange rate at the time of
expiration of contract is lower than the contract price.
d. if a forward contract is used to hedge payables or receivables and the amount to be
received or paid is cancelled.
ANS: B

If a currency's forward rate exhibits a discount, the currency is forced to appreciate.


a. True
b. False

ANS: F

If the spot rate of the British pound is $1.50, and the one-year forward rate has a discount of 3 percent, the
one-year forward rate is $____.
a. 1.50
b. 1.47
c. 1.55
d. 1.46
e. None of the above
ANS: D

Assume that the British pound () futures price for September is $1.60. Given that 62,500 units are in a
British pound futures contract, the seller of British pound futures will receive $____ on the delivery
date.
a. 39,062.50
b. 100,000
c. 48,000
d. 87,062.50
ANS: B

15
Which of the following is not true regarding options?
a. Options are traded on exchanges, never over-the-counter.
b. Similar to futures contracts, margin requirements are normally imposed on option traders.
c. Although commissions for options are fixed per transaction, multiple contracts may be
involved in a transaction, thus lowering the commission per contract.
d. Currency options can be classified as either put or call options.
e. All of the above are true.
ANS: A

16
Multiple Choice Questions and Answers Lecture 6

A strong dollar is normally expected to cause:


a. high unemployment and high inflation in the U.S.
b. high unemployment and low inflation in the U.S.
c. low unemployment and low inflation in the U.S.
d. low unemployment and high inflation in the U.S.
ANS: B

A primary result of the Smithsonian Agreement was:


a. the establishment of the European Monetary System (EMS).
b. establishing that exchange rates of most major countries were to be allowed to fluctuate
2.25% above or below their initially set values.
c. establishing specific rules for when tariffs and quotas could be imposed by governments.
d. establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to intervene when
necessary).
ANS: B

A strong dollar places ____ pressure on inflation, which in turn places ____ pressure on the dollar.
a. upward; upward
b. downward; upward
c. upward; downward
d. downward; downward
ANS: B

The euro is the currency:


a. adopted in all western European countries as of 1999.
b. adopted in all eastern European countries as of 1999.
c. adopted in all European countries as of 1999.
d. none of the above
ANS: D

The euro has not been adopted by:


a. Slovenia.
b. the U.K.
c. Germany.
d. France.
ANS: B

1
The exchange rate mechanism (ERM) refers to the method of linking ____ currencies to each other within
boundaries.
a. Latin American
b. European
c. Asian
d. North American
ANS: B

Countries that have adopted the euro must agree on a single ____ policy.
a. monetary
b. fiscal
c. worker compensation
d. foreign relations
ANS: A

Countries that have adopted the euro tend to have very similar ____.
a. interest rates
b. inflation rates
c. income tax rates
d. budget deficits
ANS: A

Which of the following is true regarding the euro?


a. Exchange rate risk between participating European currencies is completely eliminated,
encouraging more trade and capital flows across European borders.
b. It allows for more consistent economic conditions across countries.
c. It prevents each country from conducting its own monetary policy.
d. All of the above are true.
ANS: D

As foreign exchange activity has grown, a given degree of central bank intervention has become:
a. more effective.
b. more frequent.
c. less effective.
d. none of the above
ANS: C

When using indirect intervention, a central bank is likely to focus on:


a. inflation.
b. interest rates.
c. income levels.
d. expectations of future exchange rates.
ANS: B

2
Which of the following is not true regarding Thailand?
a. Thailand was one of the slowest growing countries before the Asian crisis.
b. High levels of spending and low levels of saving placed upward pressure on prices of real
estate, products, and on Thailand's local interest rate.
c. Thailand's baht was linked to the dollar prior to July 1997, which made Thailand an
attractive site for foreign investors.
d. Thai banks provided many loans that were very risky in their attempt to make use of all of
their funds.
e. All of the above are true.
ANS: A

Which of the following are examples of currency controls?


a. import restrictions.
b. prohibition of remittance of funds.
c. ceilings on granting credit to foreign firms.
d. all of the above
ANS: D

From a financial management perspective, which of the following is true regarding the introduction of the
Euro?
a. U.S.-based MNCs are not subject to exchange rate risk when they have transactions in
euros.
b. The euro is pegged to all other European currencies.
c. Transactions costs decline for MNCs that conduct transactions within Europe.
d. The euro replaced the British pound.
ANS: C

Which of the following are true about the Southeast Asian currency crisis?
a. It was preceded by several years of large capital inflows to Asia.
b. It was preceded by a five-year recession in Asia.
c. Asian interest rates declined during the crisis.
d. Asian exchange rates were pegged to the Japanese yen to resolve the crisis.
ANS: A

Under a fixed exchange rate system, U.S. inflation would have a greater impact on inflation in other
countries than it would under a freely floating exchange rate system.
a. True
b. False

ANS: T

An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in
the foreign exchange market to maintain exchange rates within specified boundaries.

3
a. True
b. False

ANS: F

A major advantage of the euro is the complete elimination of exchange rate risk on transactions between
participating European countries, which encourages more trade and capital flows within Europe.
a. True
b. False

ANS: T

The Smithsonian Agreement called for a devaluation of the U.S. dollar by about ____ percent.
a. 2.25
b. 6
c. 10
d. 8
ANS: D

Which of the following did not occur as a result of Bretton Woods Agreement?
a. Each currency was valued in terms of gold.
b. Values of all currencies were fixed with respect to each other.
c. Currencies were allowed to fluctuate no more than 1% above or below the initially set
rates.
d. The United States experienced no balance-of-trade deficits.
ANS: D

A "dirty" float represents a system of:


a. freely floating exchange rates.
b. fixed exchange rates.
c. floating exchange rates, but the central bank can manipulate the currency.
d. fixed exchange rates, but the central bank can manipulate the currency.
ANS: C

Which of the following is not true regarding the eurozone?


a. Members cannot set unique monetary policy individually.
b. Members cannot apply their own fiscal policies.
c. Members have to agree on the ideal monetary policy.
d. Its creation allowed for greater political union among its members.
ANS: B

Which of the following is not a reason for devaluation of a currency?


a. high inflation.

4
b. to reduce balance-of-trade deficit.
c. to decrease the amount of imports.
d. high unemployment.
ANS: A

Which of the following is the most likely reason for revaluation of a currency?
a. To reduce inflation.
b. To stimulate the local economy.
c. To increase the amount of exports.
d. To increase balance-of-trade surplus.
ANS: A

Direct intervention is usually more effective than indirect intervention.


a. True
b. False

ANS: F

A primary result of the Bretton Woods Agreement was:


a. the establishment of the European Monetary System (EMS).
b. establishing specific rules for when tariffs and quotas could be imposed by governments.
c. establishing that exchange rates of most major currencies were to be allowed to fluctuate
1% above or below their initially set values.
d. establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to intervene when
necessary).
ANS: C

Assume Countries A, B, and C produce goods that are substitutes of each other and that these countries
engage in trade with each other. Assume that Country A's currency floats against Country B's
currency, and that Country C's currency is pegged to B's. If A's currency depreciates against B, then
A's exports to C should ____, and A's imports from C should ____.
a. decrease; increase
b. decrease; decrease
c. increase; decrease
d. increase; increase
ANS: C

If foreign investors fear that a peg may be broken because of fund outflows from that country, they may
attempt to purchase more of that currency before the peg is broken.
a. True
b. False

ANS: F

5
To weaken the dollar using sterilized intervention, the Fed will ____ U.S. dollars and simultaneously ____
Treasury securities.
a. buy; sell
b. sell; sell
c. sell; buy
d. buy; sell
ANS: B

If the Fed desires to strengthen the dollar without affecting the dollar money supply, it should:
a. exchange dollars for foreign currencies, and sell some of its existing Treasury security
holdings for dollars.
b. exchange foreign currencies for dollars, and sell some of its existing Treasury security
holdings for dollars.
c. exchange dollars for foreign currencies, and buy existing Treasury securities with dollars.
d. exchange foreign currencies for dollars, and buy existing Treasury securities with dollars.
ANS: D

If the Fed ____ the interest rates when inflationary expectations remain unchanged, the most likely result is
that the value of dollar will ____ and the economy may ____.
a. increases; appreciate; weaken
b. decreases; appreciate; weaken
c. increases; depreciate; strengthen
d. decreases; appreciate; strengthen
ANS: A

A common way to reduce inflation is to weaken the value of the domestic currency.
a. True
b. False

ANS: F

In a freely floating exchange rate system, high U.S. inflation rate may be magnified. This is because the
depreciation of the dollar would result in more expensive foreign imports, thus reducing foreign
competition.
a. True
b. False

ANS: T

Which of the following is not true regarding the Mexican peso crisis?
a. Mexico encouraged firms and consumers to buy an excessive amount of imports because
the peso was stronger than it should have been.
b. Many speculators based in the U.S. speculated on the potential decline in the peso by

6
investing their funds in Mexico.
c. In December of 1994, the central bank of Mexico allowed the peso to float freely.
d. The central bank of Mexico increased interest rates after the peso declined in value in
order to prevent investors from withdrawing their investments in Mexico's debt securities.
e. All of the above are true.
ANS: B

Which of the following is an appropriate form of indirect intervention?


a. To strengthen the dollar, the Fed increases the money supply to lower interest rates.
b. To weaken the dollar, the Fed reduces the money supply to increase interest rates.
c. To strengthen the dollar in the long run, the Fed attempts to reduce U.S. inflation.
d. To weaken the dollar in the long run, the Fed attempts to reduce U.S. inflation.
ANS: C

Assume that the dollar has been consistently depreciating over a long period. The Fed decides to counteract
this movement by intervening in the foreign exchange market using sterilized intervention. The Fed
would
a. buy dollars with foreign currency and simultaneously sell Treasury securities for dollars.
b. buy dollars with foreign currency and simultaneously buy Treasury securities with dollars.
c. sell dollars for foreign currency and simultaneously sell Treasury securities for dollars.
d. sell dollars for foreign currency and simultaneously buy Treasury securities with dollars.
e. none of the above
ANS: B

While a strong currency is a possible cure for high inflation, it may cause higher unemployment due to the
attractive foreign prices that result from a strong home currency.
a. True
b. False

ANS: T

While a weak currency can reduce unemployment at home, it can also lead to higher inflation, as local
companies are better able to raise prices.
a. True
b. False

ANS: T

Assume the Fed desires to strengthen the dollar. If it buys dollars and simultaneously buys Treasury
securities, this is an example of sterilized intervention.
a. True
b. False

7
ANS: T

An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in
the foreign exchange market to maintain exchange rates within specified boundaries.
a. True
b. False

ANS: F

8
Multiple Choice Questions and Answers Lecture 7

Due to ____, market forces should realign the spot rate of a currency among banks.
a. forward realignment arbitrage
b. triangular arbitrage
c. covered interest arbitrage
d. locational arbitrage
ANS: D

When using ____, funds are not tied up for any length of time.
a. covered interest arbitrage
b. locational arbitrage
c. triangular arbitrage
d. B and C
ANS: D

When using ____, funds are typically tied up for a significant period of time.
a. covered interest arbitrage
b. locational arbitrage
c. triangular arbitrage
d. B and C
ANS: A

Assume the British pound is worth $1.60, and the Canadian dollar is worth $.80. What is the value of the
Canadian dollar in pounds?
a. 2.0.
b. 2.40.
c. .80.
d. .50.
e. none of the above
ANS: D
SOLUTION: $.80/$1.60 = 0.50

Assume that the euro's interest rates are higher than U.S. interest rates, and that interest rate parity exists.
Which of the following is true?
a. Americans using covered interest arbitrage earn the same rate of return as Germans who
attempt covered interest arbitrage.
b. Americans who invest in the U.S. earn the same rate of return as Germans who attempt
covered interest arbitrage.
c. Americans who invest in the U.S. earn the same rate of return as Germans who invest in
Germany
d. A and B
e. None of the above
ANS: E

1
According to interest rate parity (IRP):
a. the forward rate differs from the spot rate by a sufficient amount to offset the inflation
differential between two currencies.
b. the future spot rate differs from the current spot rate by a sufficient amount to offset the
interest rate differential between two currencies.
c. the future spot rate differs from the current spot rate by a sufficient amount to offset the
inflation differential between two currencies.
d. the forward rate differs from the spot rate by a sufficient amount to offset the interest rate
differential between two currencies.
ANS: D

If the cross exchange rate of two nondollar currencies implied by their individual spot rates with respect to
the dollar is less than the cross exchange rate quoted by a bank, locational arbitrage is possible.
a. True
b. False

ANS: F

For locational arbitrage to be possible, one bank's ask rate must be higher than another bank's bid rate for a
currency.
a. True
b. False

ANS: F

Assume locational arbitrage is possible and involves two different banks. The realignment that would occur
due to market forces would increase one bank's ask rate and would decrease the other bank's bid rate.
a. True
b. False

ANS: T

Triangular arbitrage tends to force a relationship between the interest rates of two countries and their forward
exchange rate premium or discount.
a. True
b. False

ANS: F

If interest rate parity (IRP) exists, then triangular arbitrage will not be possible.
a. True
b. False

ANS: F

2
Forward rates are driven by the government rather than market forces.
a. True
b. False

ANS: F

Points below the IRP line represent situations where:


a. covered interest arbitrage is feasible from the perspective of domestic investors and results
in the same yield as investing domestically.
b. covered interest arbitrage is feasible from the perspective of domestic investors and results
in a yield above what is possible domestically.
c. covered interest arbitrage is feasible from the perspective of foreign investors and results
in a yield above what is possible in their local markets.
d. covered interest arbitrage is not feasible for neither domestic nor foreign investors.
ANS: B

Which of the following is not mentioned in the text as a form of international arbitrage?
a. Locational arbitrage
b. Triangular arbitrage
c. Transactional arbitrage
d. Covered interest arbitrage
e. All of the above are mentioned in the text as forms of international arbitrage.
ANS: C

If the interest rate is lower in the U.S. than in the United Kingdom, and if the forward rate of the British
pound is the same as its spot rate:
a. U.S. investors could possibly benefit from covered interest arbitrage.
b. British investors could possibly benefit from covered interest arbitrage.
c. neither U.S. nor British investors could benefit from covered interest arbitrage.
d. A and B
ANS: A

Assume that Swiss investors are benefiting from covered interest arbitrage due to a high U.S. interest rate.
Which of the following forces results from the act of this covered interest arbitrage?
a. upward pressure on the Swiss franc's spot rate.
b. upward pressure on the U.S. interest rate.
c. downward pressure on the Swiss interest rate.
d. upward pressure on the Swiss franc's forward rate.
ANS: D

3
Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X. Assume the bid rate of
a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z. Given this information, what would
be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end
up with over and above the $1,000,000 you started with?
a. $11,764.
b. $11,964.
c. $36,585.
d. $24,390.
e. $18,219.
ANS: D
SOLUTION: $1,000,000/$.41 = S2,439,024 $.42 = $1,024,390

Assume the following information:

Spot rate today of Swiss franc = $.60


1-year forward rate as of today for Swiss franc = $.63
Expected spot rate 1 year from now = $.64
Rate on 1-year deposits denominated in Swiss francs = 7%
Rate on 1-year deposits denominated in U.S. dollars = 9%

From the perspective of U.S. investors with $1,000,000, covered interest arbitrage would yield a rate
of return of ____%.
a. 5.00
b. 12.35
c. 15.50
d. 14.13
e. 11.22
ANS: B
SOLUTION: $1,000,000/$.60 = SF1,666,667 (1.07)
= SF1,783,333 $.63 = $1,123,500
Yield = ($1,123,500 $1,000,000)/$1,000,000 = 12.35%

Assume that British interest rates are higher than U.S. rates, and that the spot rate equals the forward rate.
Covered interest arbitrage puts ____ pressure on the pound's spot rate, and ____ pressure on the
pound's forward rate.
a. downward; downward
b. downward; upward
c. upward; downward
d. upward; upward
ANS: C

4
Assume the following information:

You have $1,000,000 to invest:


Current spot rate of pound = $1.60
90-day forward rate of pound = $1.57
3-month deposit rate in U.S. = 3%
3-month deposit rate in U.K. = 4%

If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars
you will have after 90 days?
a. $1,020,500.
b. $1,045,600.
c. $1,073,330.
d. $1,094,230.
e. $1,116,250.
ANS: A
SOLUTION: $1,000,000/$1.60 = 625,000 pounds (1.04) = 650,000 pounds 1.57 =
$1,020,500

Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask
Bank C $1.61 $1.63
Bank D $1.58 $1.60

As locational arbitrage occurs:


a. the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will
increase.
b. the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will
decrease.
c. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will
decrease.
d. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will
increase.
ANS: D

Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. Assume the bid rate
of an Australian dollar is $.62 while the ask rate is $.625 at Bank V. Given this information, what
would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will
you end up with over and above the $1,000,000 you started with?
a. $10,003.
b. $12,063.
c. $14,441.
d. $16,393.
e. $18,219.
ANS: D
SOLUTION: $1,000,000/$.61 = A$1,639,344 $.62 = $1,016,393. Thus, the profit is
$16,393.

5
Which of the following is an example of triangular arbitrage initiation?
a. buying a currency at one bank's ask and selling at another bank's bid, which is higher than
the former bank's ask.
b. buying Singapore dollars from a bank (quoted at $.55) that has quoted the South African
rand (SAR)/Singapore dollar (S$) exchange rate at SAR2.50 when the spot rate for the
rand is $.20.
c. buying Singapore dollars from a bank (quoted at $.55) that has quoted the South African
rand/Singapore dollar exchange rate at SAR3.00 when the spot rate for the rand is $.20.
d. converting funds to a foreign currency and investing the funds overseas.
ANS: C

You just received a gift from a friend consisting of 1,000 Thai baht, which you would like to exchange for
Australian dollars (A$). You observe that exchange rate quotes for the baht are currently $.023, while
quotes for the Australian dollar are $.576. How many Australian dollars should you expect to receive
for your baht?
a. A$39.93.
b. A$25,043.48.
c. A$553.00.
d. none of the above
ANS: A
SOLUTION: $.023/$.576 THB1,000 = A$39.93.

Assume the following information:

You have $900,000 to invest:


Current spot rate of Australian dollar (A$) = $.62
180-day forward rate of the Australian dollar = $.64
180-day interest rate in the U.S. = 3.5%
180-day interest rate in Australia = 3.0%

If you conduct covered interest arbitrage, what is the dollar profit you will have realized after 180
days?
a. $56,903.
b. $61,548.
c. $27,000.
d. $31,500.
ANS: A
SOLUTION: $900,000/$.62 = A$1,451,612 (1.03) = A$1,495,161 $.64 = $956,903.
Thus, the profit is $56,903.

6
Assume that interest rate parity holds. The Mexican interest rate is 50%, and the U.S. interest rate is 8%.
Subsequently, the U.S. interest rate decreases to 7%. According to interest rate parity, the peso's
forward ____ will ____.
a. premium; increase
b. discount; decrease
c. discount; increase
d. premium; decrease
ANS: C

The interest rate on euros is 8%. The interest rate in the U.S. is 5%. The euro's forward rate should exhibit a
premium of about 3%.
a. True
b. False

ANS: F

Realignment in the exchange rates of banks will eliminate locational arbitrage. More specifically, market
forces will increase the ask rate of the bank from which the currency was bought to conduct locational
arbitrage and will decrease the bid rate of the bank to which the currency was sold to conduct
locational arbitrage.
a. True
b. False

ANS: T

If quoted exchange rates are the same across different locations, then ____ is not feasible.
a. triangular arbitrage
b. covered interest arbitrage
c. locational arbitrage
d. A and C
ANS: D

Assume that interest rate parity holds. U.S. interest rate is 13% and British interest rate is 10%. The forward
rate on British pounds exhibits a ____ of ____ percent.
a. discount; 2.73
b. premium; 2.73
c. discount; 3.65
d. premium; 3.65
ANS: B

7
Assume the following information:

Exchange rate of Japanese yen in U.S. $ = $.011


Exchange rate of euro in U.S. $ = $1.40
Exchange rate of euro in Japanese yen = 140 yen

What will be the yield for an investor who has $1,000,000 available to conduct triangular arbitrage?
a. $100,000
b. $90,909
c. 10%
d. 9.09%
ANS: C
SOLUTION: Exchange dollars for pounds = $1,000,000/$1.4 = 714.286; exchange pounds
for yen = 714,286 140 = 100,000,000 yen. Exchange yen for dollars =
100,000,000 yen $.011 = $1,100,000. Yield = ($1,100,000
$1,000,000)/$1,000,000 = 10%

Assume that the real interest rate in the U.S. and in the U.K. is 3%. The expected annual inflation in the U.S.
is 3%, while in the U.K. it is 4%. The forward rate on the pound should exhibit a premium of about
1%.
a. True
b. False

ANS: F

American Bank quotes a bid rate of $0.026 and an ask rate of $0.028 for the Indian rupee (INR); National
Bank quotes a bid rate of $0.024 and an ask rate for $0.025. Locational arbitrage would involve:
a. buying rupees from American Bank at the bid rate and selling them to National Bank at
the ask rate.
b. buying rupees from National Bank at the ask rate and selling them to American Bank at
the bid rate.
c. buying rupees from American Bank at the ask rate and selling to National Bank at the bid
rate.
d. buying rupees from National Bank at the bid rate and selling them to American Bank at
the ask rate.
e. Locational arbitrage is not possible in this case.
ANS: B

Which of the following is an example of triangular arbitrage initiation?


a. Buying a currency at one bank's ask and selling at another bank's bid, which is higher than
the former bank's ask.
b. Buying Singapore dollars from a bank (quoted at $0.55) that has quoted the South African
rand (ZAR)/Singapore dollar (S$) exchange rate at ZAR2.50 when the spot rate for the
South African rand is $0.20.
c. Buying Singapore dollars from a bank (quoted at $0.55) that has quoted the South African
rand/Singapore dollar exchange rate at ZAR3.00 when the spot rate for the South African
rand is $0.20.
d. Converting funds to a foreign currency and investing the funds overseas.
ANS: C

8
Multiple Choice Questions and Answers Lecture 8

Given a home country and a foreign country, purchasing power parity suggests that:
a. the inflation rates of both countries will be the same.
b. the nominal interest rates of both countries will be the same.
c. A and B
d. none of the above
ANS: D

If interest rate parity holds, then the one-year forward rate of a currency will be ____ the predicted spot rate
of the currency in one year according to the international Fisher effect.
a. greater than
b. less than
c. equal to
d. answer is dependent on whether the forward rate has a discount or premium
ANS: C

The Fisher effect is used to determine the:


a. real inflation rate.
b. real interest rate.
c. real spot rate.
d. real forward rate.
ANS: B

Latin American countries have historically experienced relatively high inflation, and their currencies have
weakened. This information is somewhat consistent with the concept of:
a. interest rate parity.
b. locational arbitrage.
c. purchasing power parity.
d. the exchange rate mechanism.
ANS: C

Which of the following is indicated by research regarding purchasing power parity (PPP)?
a. PPP clearly holds in the short run.
b. Deviations from PPP are reduced in the long run.
c. PPP clearly holds in the long run.
d. There is no relationship between inflation differentials and exchange rate movements in
the short run or long run.
ANS: B

1
Which of the following theories suggests that the percentage change in spot exchange rate of a currency
should be equal to the inflation differential between two countries?
a. purchasing power parity (PPP).
b. triangular arbitrage.
c. international Fisher effect (IFE).
d. interest rate parity (IRP).
ANS: A

Which of the following theories suggests that the percentage difference between the forward rate and the spot
rate depends on the interest rate differential between two countries?
a. purchasing power parity (PPP).
b. triangular arbitrage.
c. international Fisher effect (IFE).
d. interest rate parity (IRP).
ANS: D

If purchasing power parity holds, then the Fisher effect must also hold.
a. True
b. False

ANS: F

According to the international Fisher effect, if Venezuela has a much higher nominal rate than other
countries, its inflation rate will likely be ____ than other countries, and its currency will ____.
a. lower; strengthen
b. lower; weaken
c. higher; weaken
d. higher; strengthen
ANS: C

The following regression analysis was conducted for the inflation rate information and exchange rate of the
British pound:

Regression results indicate that a0 = 0 and a1 = 2. Therefore:


a. purchasing power parity holds.
b. purchasing power parity overestimated the exchange rate change during the period under
examination.
c. purchasing power parity underestimated the exchange rate change during the period under
examination.
d. purchasing power parity will overestimate the exchange rate change of the British pound

2
in the future.
ANS: C

The interest rate in the U.K. is 7%, while the interest rate in the U.S. is 5%. The spot rate for the British
pound is $1.50. According to the international Fisher effect (IFE), the British pound should adjust to a
new level of:
a. $1.47.
b. $1.53.
c. $1.43.
d. $1.57.
ANS: A
SOLUTION: (1.05/1.07) (1.50) = $1.47.

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively
high interest rates should have forward discounts and those currencies would be expected to
depreciate.
a. True
b. False

ANS: T

Assume that the one-year interest rate in the U.S. is 7% and in the U.K. is 5%. According to the international
Fisher effect, British pound's spot exchange rate should ____ by about ____ over the year.
a. depreciate; 1.9%
b. appreciate; 1.9%
c. depreciate; 3.94%
d. appreciate; 3.94%
ANS: B
SOLUTION: (1 + .07)/(1 + .05) 1 = 1.9%

Assume that the international Fisher effect (IFE) holds between the U.S. and the U.K. The U.S. inflation is
expected to be 5%, while British inflation is expected to be 3%. The interest rates offered on pounds
are 7% and U.S. interest rates are 7%. What does this say about real interest rates expected by British
investors?
a. real interest rates expected by British investors are equal to the interest rates expected by
U.S. investors.
b. real interest rates expected by British investors are 2 percentage points lower than the real
interest rates expected by U.S. investors.
c. real interest rates expected by British investors are 2 percentage points above the real
interest rates expected by U.S. investors.
d. IFE doesn't hold in this case because the U.S. inflation is higher than the British inflation,
but the interest rates offered in both countries are equal.
ANS: C

3
The inflation rate in the U.S. is 4%, while the inflation rate in Japan is 1.5%. The current exchange rate for
the Japanese yen () is $0.0080. After supply and demand for the Japanese yen has adjusted according
to purchasing power parity, the new exchange rate for the yen will be
a. $0.0078.
b. $0.0082.
c. $0.0111.
d. $0.00492.
e. None of the above
ANS: B

Among the reasons that purchasing power parity (PPP) does not consistently occur are:
a. exchange rates are affected by interest rate differentials.
b. exchange rates are affected by national income differentials and government controls.
c. supply and demand may not adjust if no substitutable goods are available.
d. all of the above are reasons that PPP does not consistently occur.
ANS: D

The following regression was conducted for the exchange rate of the Cyprus pound (CYP):

Regression results indicate that a0 = 0 and a1 = 2. Therefore,


a. purchasing power parity holds.
b. purchasing power parity overestimated the exchange rate change during the period under
examination.
c. purchasing power parity underestimated the exchange rate change during the period under
examination.
d. purchasing power parity will overestimate the exchange rate change of the Cyprus pound
in the future.
ANS: C

According to the IFE, when the nominal interest rate at home exceeds the nominal interest rate in the foreign
country, the home currency should depreciate.
a. True
b. False

ANS: T

4
The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will
appreciate because those high rates will attract investment and increase the demand for that currency.
a. True
b. False

ANS: F

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively
high interest rates should have forward discounts and those currencies would be expected to
depreciate.
a. True
b. False

ANS: T

5
END OF CHAPTER 1 QUESTIONS AND ANSWERS

International Opportunities

a. Do you think that either the acquisition of a foreign firm or licensing will result in greater
growth for an MNC? Which alternative is likely to have more risk?

ANSWER: An acquisition will typically result in greater growth, but it is more risky because it
normally requires a larger investment and the decision can not be easily reversed once the
acquisition is made.

b. Describe a scenario in which the size of a corporation is not affected by access to


international opportunities.

ANSWER: Some firms may avoid opportunities because they lack knowledge about foreign
markets or expect that the risks are excessive. Thus, the size of these firms is not affected by the
opportunities.

c. Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous opportunities
for international expansion.

ANSWER: Coca Cola and PepsiCo still have new international opportunities because countries
are at various stages of development. Some countries have just recently opened their borders to
MNCs. Many of these countries do not offer sufficient food or drink products to their consumers.

Impact of Exchange Rate Movements

Plak Co. of Chicago has several European subsidiaries that remit earnings to it each year. Explain
how appreciation of the euro (the currency used in many European countries) would affect Plak's
valuation.

ANSWER: Plaks valuation should increase because the appreciation of the euro will increase the
dollar value of the cash flows remitted by the European subsidiaries

1
Exposure to Exhange Rates.

McCanna Corp., a U.S. firm, has a French subsidiary that produces wine and exports to various
European countries. All of the countries where it sells its wine use the euro as their currency,
which is the same as the currency used in France. Is McCanna Corp. exposed to exchange rate
risk?

ANSWER: The subsidiary and its customers based in countries that now use the euro as their
currency would no longer be exposed to exchange rate risk. However, McCanna Corp is exposed
to exchange rate risk, because the subsidiary will ultimately remit its earnings to the parent, and
the euro earnings will be converted to dollars when they are remitted.

Impact of September 11.

Following the terrorist attack on the U.S., the valuations of many MNCs declined by more than
10 percent. Explain why the expected cash flows of MNCs were reduced, even if they were not
directly hit by the attacks.

ANSWER: An MNCs cash flows could be reduced in the following ways. First, a decline in
travel would affect any MNCs that have business in travel-related industries. The airline, hotel,
and tourist-related industries were expected to experience a decline in business. Layoffs were
announced immediately by many of these MNCs. Second, these effects on travel-related
industries can carry over to other industries, and weaken economies. Third, the cost of
international trade increased as a result of tighter restrictions on some products. Fourth, some
MNCs incurred expenses as a result of increasing security to protect their employees.

Valuation of an MNC.

Birm Co., based in Alabama, is considering several international opportunities in Europe that
could affect the value of its firm. The valuation of its firm is dependent on four factors: (1)
expected cash flows in dollars, (2) expected cash flows in euros that are ultimately converted into
dollars, (3) the rate at which it can convert euros to dollars, and (4) Birms weighted average cost
of capital. For each opportunity, identify the factors that would be affected.

a. Birm plans a licensing deal in which it will sell technology to a firm in Germany for
$3,000,000; the payment is invoiced in dollars, and this project has the same risk level as its
existing businesses.
b. Birm plans to acquire a large firm in Portugal that is riskier than its existing businesses.
c. Birm plans to discontinue its relationship with a U.S. supplier so that can import a small
amount of supplies (denominated in euros) at a lower cost from a Belgian supplier.
d. Birm plans to export a small amount of materials to Ireland that are denominated in euros.

2
ANSWER:

Exchange rate at Birms weighted


which Birm Co. average cost of
Opportunity Dollar CF Euro CF
converts euros to capital
dollars

a. joint venture X

b. acquisition X X

c. imported supplies X

d. exports to Ireland X

Impact of International Business on Cash Flows and Risk.

Nantucket Travel Agency specializes in tours for American tourists. Until recently, all of its
business was in the U.S. It just established a subsidiary in Athens, Greece, which provides tour
services in the Greek islands for American tourists. It rented a shop near the port of Athens. It also
hired residents of Athens, who could speak English and provide tours of the Greek islands. The
subsidiarys main costs are rent and salaries for its employees and the lease of a few large boats in
Athens that it uses for tours. American tourists pay for the entire tour in dollars at Nantuckets
main U.S. office before they depart for Greece.

a. Explain why Nantucket may be able to effectively capitalize on international opportunities


such as the Greek island tours.

ANSWER: It already has established credibility with American tourists, but could penetrate a
new market with some of the same customers that it has served on tours in the U.S.

b. Nantucket is privately-owned by owners who reside in the U.S. and work in the main office.
Explain possible agency problems associated with the creation of a subsidiary in Athens,
Greece. How can Nantucket attempt to reduce these agency costs?

ANSWER: The employees of the subsidiary in Athens are not owners, and may have no incentive
to manage in a manner that maximizes the wealth of the owners. Thus, they may manage the tours
inefficiently.

3
Nantucket could attempt to allow the employees a portion of the ownership of the company so
that they benefit more directly from good performance. Alternatively, Nantucket may consider
having one of its owners transfer to Athens to oversee the subsidiarys operations.

c. Greeces cost of labor and rent are relatively low. Explain why this information is relevant to
Nantuckets decision to establish a tour business in Greece.

ANSWER: The low cost of rent and labor will be beneficial to Nantucket, because it enables
Nantucket to create the subsidiary at a low cost.

d. Explain how the cash flow situation of the Greek tour business exposes Nantucket to
exchange rate risk. Is Nantucket favorably or unfavorably affected when the euro (Greeces
currency) appreciates against the dollar? Explain.

ANSWER: Nantuckets tour business in Greece results in dollar cash inflows and euro cash
outflows. It will be adversely affected by the appreciation of the euro because it will require more
dollars to cover the costs in Athens if the euros value rises.

e. Nantucket plans to finance its Greek tour business. Its subsidiary could obtain loans in euros
from a bank in Greece to cover its rent, and its main office could pay off the loans over time.
Alternatively, its main office could borrow dollars and would periodically convert dollars to
euros to pay the expenses in Greece. Does either type of loan reduce the exposure of
Nantucket to exchange rate risk? Explain.

ANSWER: No. The euro loans would be used to cover euro expenses, but Nantucket would need
dollars to pay off the loans. Alternatively, the U.S. dollar loans would still require conversion of
dollars to euros. With either type of loan, Nantucket is still adversely affected by the appreciation
of the euro against the dollar.

f. Explain how the Greek island tour business could expose Nantucket to country risk.

ANSWER: The subsidiary could be subject to government restrictions or taxes in Greece that
would place it at a disadvantage relative to other Greek tour companies based in Athens.

4
Impact of the Credit Crisis on MNC Value.

Much of the attention to the credit crisis was focused on its adverse effects on financial institutions,
but many other types of firms were also affected. Explain why the numerator of the MNC valuation
equation was affected during the period of October 6-10. Explain how the denominator of the MNC
valuation equation was affected during that period.

ANSWER: The numerator of the MNC valuation equation represents cash flows. In October,
2008, the credit crisis intensified. Investors were concerned that the economic conditions in the
U.S. and in many other countries would deteriorate, which resulted in expectations of a reduced
demand for exports produced by U.S. firms. In addition, it resulted in expectations of reduced
earnings of foreign subsidiaries, and therefore a reduction in remitted earnings to the MNCs
parent. These revised expectations reflected a reduction in cash flows to be received by the parent,
and therefore caused reduced valuations of MNCs.

The denominator of the MNC valuation equation reflects the cost of capital. The crisis increased
the uncertainty surrounding the future cash flows, meaning that that there was greater downside
risk (that the cash flows could be much worse than expected). MNCs experienced a higher cost of
capital, and therefore a higher required rate of return. Consequently, expected cash flows were
discounted at a higher rate, which reduced the valuations of the MNCs.

Estimating an MNC's Cash Flows.

Biloxi Co. is a U.S. firm with a subsidiary in China. The subsidiary reinvests half of its net cash
flows into operations and remits half to the parent. Biloxi Co. has expected cash flows of
$10,000,000 from domestic business and the Chinese subsidiary is expected to generate 100
million Chinese yuan at the end of the year. The expected value of yuan at the end of the year is
$.13. What are the expected dollar cash flows of the parent of Biloxi Co. in one year?

ANSWER

[$10,000,000 + 100,000,000]/2[$.13] = 16,500,000.

Uncertainty Surrounding an MNC's Cash Flows.

a. Assume that Bangor Co. (a U.S. firm) knows that it will have cash inflows of $900,000 from
domestic operations, cash inflows of 200,000 Swiss francs resulting from exports to Swiss
operations, and cash outflows of 500,000 Swiss francs at the end of the year. Although the future
value of the Swiss franc is uncertain, your best guess is that it will be worth $1.10 at the end of
this year. What are the expected dollar cash flows of Bangor Co?

5
b. Assume that Concord Co. (a U.S. firm) is in the same industry as Bangor Co. There is no
political risk that could have any impact on the cash flows of either firm. Concord Co. knows that
it will have cash inflows of $900,000 from domestic operations, cash inflows of 700,000 Swiss
francs from exports to Swiss operations, and cash outflows of 800,000 Swiss francs at the end of
the year. Is the valuation of the total cash flows of Concord Co. more uncertain or less uncertain
than the total cash flows of Bangor Co.? Explain briefly.

ANSWER

a. $900,000 + (-$300,000 x $1.10) = $570,000

b. The cash flows of Bangor are more uncertain because a larger proportion of the cash flows are
subject to exchange rate risk.

6
International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 1- Overview of multinational financial
management
Dr. Vassilios Papavassiliou
Business eLearning
Chapter objectives
Identify the management goal and organizational
structure of the Multinational Corporation (MNC)
Describe the key theories that justify
international business
Explain the common methods used to conduct
international business
Provide a model for valuing the MNC

Overview of multinational financial


management
Managing the MNC
Managers are expected to make decisions that
will maximize the stock price.

Focus of this text: MNCs whose parents fully own


foreign subsidiaries (e.g. Dow Chemical, IBM,
Nike, Colgate-Palmolive - U.S. parent is sole
owner of subsidiary)

Overview of multinational financial


management
Managing the MNC
How Business Disciplines Are Used to Manage
the MNC
Common finance decisions include:
Whether to discontinue operations in a particular country
Whether to pursue new business in a particular country
Whether to expand business in a particular country
How to finance expansion in a particular country
Finance decisions are influenced by other business
discipline functions:
Marketing
Management
Accounting and information systems

Overview of multinational financial


management
Managing the MNC
Agency Problems
The conflict of goals between managers and
shareholders
Agency Costs
Definition: Cost of ensuring that managers maximize
shareholder wealth
Costs are normally higher for MNCs than for purely
domestic firms for several reasons:
Monitoring managers of distant subsidiaries in foreign
countries is more difficult.
Foreign subsidiary managers raised in different
cultures may not follow uniform goals.
Sheer size of larger MNCs can create large agency
problems.
Some non-U.S. managers tend to downplay the short-
term effects of decisions.

Overview of multinational financial


management
Managing the MNC
Agency Problems (cont.)
Parent control of agency problems
Parent should clearly communicate the goals for
each subsidiary to ensure managers focus on
maximizing the value of the subsidiary.
Corporate control of agency problems
Entire management of the MNC must be focused on
maximizing shareholder wealth.
Sarbanes-Oxley Act (SOX)
Ensures a more transparent process for managers
to report on the productivity and financial
condition of their firm.

Overview of multinational financial


management
SOX methods to improve reporting
Agency Problems (cont.)
How SOX Improved Corporate Governance
of MNCs
Establishing a centralized database of information
Ensuring that all data are reported consistently
among subsidiaries
Implementing a system that automatically checks
for unusual discrepancies relative to norms
Speeding the process by which all departments and
subsidiaries have access to all the data they need
Making executives more accountable for financial
statements

Overview of multinational financial


management
Management structure of MNC
Management Structure of MNC
Centralized (See Exhibit 1.1a)
Allows managers of the parent to control foreign
subsidiaries and therefore reduce the power of
subsidiary managers
Decentralized (See Exhibit 1.1b)
Gives more control to subsidiary managers who
are closer to the subsidiarys operation and
environment
How the Internet Facilitates Management
Control
Makes it easier for parent to monitor the actions
and performance of its foreign subsidiaries

Overview of multinational financial


management
Exhibit 1.1a Management styles of MNCs

Overview of multinational financial


management
Exhibit 1.1b Management styles of MNCs

Overview of multinational financial


management
Why firms pursue international business
Theory of Competitive Advantage:
specialization increases production efficiency.
Imperfect Markets Theory: factors of
production are somewhat immobile providing
incentive to seek out foreign opportunities.
Product Cycle Theory: as a firm matures, it
recognizes opportunities outside its domestic
market. (Exhibit 1.2)

Overview of multinational financial


management
Exhibit 1.2 International product life cycles

Overview of multinational financial


management
How firms engage in international business
International trade
Licensing
Franchising
Joint Ventures
Acquisitions of existing operations
Establishing new foreign subsidiaries

Overview of multinational financial


management
How firms engage in international business
International Trade
Relatively conservative approach that can be used by
firms to
penetrate markets (by exporting)
obtain supplies at a low cost (by importing).

Minimal risk no capital at risk


How the Internet Facilitates International
Trade
The internet facilitates international trade by allowing
firms to advertise their products and accept orders on
their websites.

Overview of multinational financial


management
How firms engage in international business
Licensing
Obligates a firm to provide its technology
(copyrights, patents, trademarks, or trade
names) in exchange for fees or some other
specified benefits.
Allows firms to use their technology in foreign
markets without a major investment and
without transportation costs that result from
exporting
Major disadvantage: difficult to ensure quality
control in foreign production process

Overview of multinational financial


management
How firms engage in international business
Franchising
Obligates firm to provide a specialized sales or service
strategy, support assistance, and possibly an initial
investment in the franchise in exchange for periodic
fees.
Allows penetration into foreign markets without a
major investment in foreign countries.
Joint Ventures
A venture that is jointly owned and operated by two
or more firms. A firm may enter the foreign market
by engaging in a joint venture with firms that reside
in those markets.
Allows two firms to apply their respective cooperative
advantages in a given project (e.g. General Mills
Nestle, Xerox-Fuji joint ventures).

Overview of multinational financial


management
How firms engage in international business
Acquisitions of Existing Operations
Acquisitions of firms in foreign countries
allows firms to have full control over their
foreign businesses and to quickly obtain a
large portion of foreign market share (e.g.
Google has acquired businesses in Australia,
Brazil, Canada, China, Germany, Russia,
South Korea among others)
Subject to the risk of large losses because of
larger investment.
Liquidation may be difficult if the foreign
subsidiary performs poorly.

Overview of multinational financial


management
How firms engage in international business
Establishing New Foreign Subsidiaries
Firms can penetrate markets by establishing
new operations in foreign countries.
Requires a large investment
Acquiring new as opposed to buying existing
allows operations to be tailored exactly to the
firms needs.
May require smaller investment than buying
existing firm.

Overview of multinational financial


management
How firms engage in international business
Summary of Methods
Any method of increasing international
business that requires a direct investment in
foreign operations is referred to as direct
foreign investment (DFI)
International trade and licensing usually not
included
Foreign acquisition and establishment of new
foreign subsidiaries represent the largest
portion of DFI.

Overview of multinational financial


management
How firms engage in international business
Summary of Methods (cont.)
Exhibit 1.3 Cash Flow Diagrams for MNCs
The first diagram reflects an MNC that engages in
international trade. International cash flows result from
paying for imports or receiving cash flow from exports.
The second diagram reflects an MNC that engages in
some international arrangements. Outflows include
expenses such as expenses incurred from transferring
technology or funding partial investment in a franchise
or joint venture. Inflows are receipts from fees.
The third diagram reflects an MNC that engages in
direct foreign investment. Cash flows exist between
the parent company and the foreign subsidiary.

Overview of multinational financial


management
Exhibit 1.3 Cash flow diagrams for MNCs

Overview of multinational financial


management
Valuation model for an MNC

E CF$,t
Domestic Model n
V t
t 1 1 k

Where
V represents present value of
expected cash flows
E(CF$,t) represents expected cash
flows to be received at the end of
period t,
n represents the number of periods
into the future in which cash flows
are received, and
k represents the required rate of
return by investors.

Overview of multinational financial


management
Valuation model for an MNC
Domestic Model (cont.)
Dollar Cash Flows
The dollar cash flows in period t represent funds
received by the firm minus funds needed to pay
expenses or taxes or to reinvest in the firm.
Cost of Capital
The required rate of return (k) in the denominator
of the valuation equation.
A weighted average of the cost of capital based on
all the firms projects.

Overview of multinational financial


management
Valuation model for an MNC

Multinational Modell


E CF$,t E CF j ,t E S j ,t
m

j 1
Where
CFj,t represents the amount of cash flow
denominated in a particular foreign
currency j at the end of period t,
Sj,t represents the exchange rate at which
the foreign currency (measured in dollars
per unit of the foreign currency) can be
converted to dollars at the end of period t.

Overview of multinational financial


management
Valuation model for an MNC
Multinational Model (cont.)
Valuation of an MNC that uses two currencies
Could measure its expected dollar cash flows in any
period by multiplying the expected cash flow in each
currency by the expected exchange rate at which that
currency would be converted to dollars and then
summing those two products.
Valuation of an MNC that uses multiple
currencies


E CF$,t E CF j ,t E S j ,t
m

j 1
Derive an expected dollar cash flow value for each
currency
Combine the cash flows among currencies within a given
period

Overview of multinational financial


management
Valuation model for an MNC

Overview of multinational financial


management
Valuation model for an MNC
Multinational Model (cont.)
Valuation of an MNCs cash flows over multiple
periods
Apply single period process to all future periods
Discount the estimated total dollar cash flow for
each period at the weighted cost of capital

E CF E S
m

n j ,t j ,t

V
j 1

1 k
t
t 1

Overview of multinational financial


management
Valuation model for an MNC
Uncertainty Surrounding MNC Cash Flows (Exhibit
1.4)
Exposure to international economic conditions
If economic conditions in a foreign country weaken,
purchase of products decline and MNC sales in that
country may be lower than expected. (Exhibit 1.5)
Exposure to international political risk A foreign
government may increase taxes or impose barriers on
the MNCs subsidiary.
Exposure to exchange rate risk If foreign
currencies related to the MNC subsidiary weaken
against the U.S. dollar, the MNC will receive a lower
amount of dollar cash flows than was expected.
Summary of International Effects (Exhibit 1.4)

Overview of multinational financial


management
Exhibit 1.4 How an MNCs valuation is exposed to
uncertainty

Overview of multinational financial


management
Exhibit 1.5 Potential effects of
international economic conditions

Overview of multinational financial


management
How uncertainty affects the MNCs cost of
capital
How Uncertainty Affects the MNCs cost of
Capital
A higher level of uncertainty increases the return
on investment required by investors and the
MNCs valuation decreases.

Overview of multinational financial


management
Summary
The main goal of an MNC is to maximize
shareholder wealth. When managers are tempted
to serve their own interests instead of those of
shareholders, an agency problem exists. MNCs
tend to experience greater agency problems than
do domestic firms. Proper incentives and
communication from the parent may help to
ensure that subsidiary managers focus on serving
the overall MNC.

Overview of multinational financial


management
Summary
International business is justified by three key
theories.
The theory of comparative advantage suggests
that each country should use its comparative
advantage to specialize in its production and rely
on other countries to meet other needs.
The imperfect markets theory suggests that
because of imperfect markets, factors of
production are immobile, which encourages
countries to specialize based on the resources
they have.
The product cycle theory suggests that after firms
are established in their home countries, they
commonly expand their product specialization in
foreign countries.

Overview of multinational financial


management
Summary
The most common methods by which firms
conduct international business are international
trade, licensing, franchising, joint ventures,
acquisitions of foreign firms, and formation of
foreign subsidiaries. Methods such as licensing
and franchising involve little capital investment
but distribute some of the profits to other parties.
The acquisition of foreign firms and formation of
foreign subsidiaries require substantial capital
investments but offer the potential for large
returns.

Overview of multinational financial


management
Summary
The valuation model of an MNC shows that the
MNCs value is favorably affected when its
expected foreign cash inflows increase, the
currencies denominating those cash inflows
increase, or the MNCs required rate of return
decreases. Conversely, the MNCs value is
adversely affected when its expected foreign cash
inflows decrease, the values of currencies
denominating those cash flows decrease
(assuming that they have net cash inflows in
foreign currencies), or the MNCs required rate of
return increases.

Overview of multinational financial


management
Thank you for your attention

Overview of multinational financial


management
International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 2- International Flow of Funds

Dr. Vassilios Papavassiliou


Business eLearning
Chapter objectives
Explain the key components of the balance of
payments,
Explain the growth in international trade activity
over time,
Explain how international trade flows are
influenced by economic factors and other factors,
Explain how international capital flows are
influenced by country characteristics,
Introduce the agencies that facilitate the
international flow of funds.

International flow of funds


Balance of payments
Definition:
Summary of transactions between domestic and
foreign residents for a specific country over a
specified period of time.

It represents an accounting of a countrys


international transactions for a period, usually a
year
It accounts for transactions by businesses,
individuals, and the government

International flow of funds


Balance of payments
Components of the Balance of Payments
Statement:
Current Account: summary of flow of funds due to
purchases of goods or services or the provision of
income on financial assets.

Capital Account: summary of flow of funds resulting


from the sale of assets between one specified country
and all other countries over a specified period of time.
Financial Account: refers to special types of
investment, including DFI and portfolio investment.

International flow of funds


Balance of payments
Current Account
Payments for merchandise and services
Merchandise exports and imports represent tangible
products that are transported between countries.
Service exports and imports represent tourism and other
services. The difference between total exports and
imports is referred to as the balance of trade.
Factor income payments
Represents income (interest and dividend payments)
received by investors on foreign investments in financial
assets (securities).
Transfer payments
Represent aid, grants, and gifts from one country to
another.

International flow of funds


Balance of payments
Current Account (cont.)
Examples of payment entries
Exhibit 2.1.
Actual current account balance
Exhibit 2.2.

International flow of funds


Exhibit 2.1 Examples of current account
transactions

International flow of funds


Exhibit 2.2 Summary of current account in
the year 2011 (billions of $)

International flow of funds


Balance of payments
Capital Account
Originally included the financial account
Includes the value of financial assets transferred
across country borders by people who move to a
different country.
Includes patents and trademarks
Relatively minor (in terms of dollar amounts) to
financial account.

International flow of funds


Balance of payments
Financial Account
Direct foreign investment
Investments in fixed assets in foreign countries
Portfolio investment
Transactions involving long term financial assets (such as
stocks and bonds) between countries that do not affect the
transfer of control.
Other capital investment
Transactions involving short-term financial assets (such as
money market securities) between countries.
Errors and omissions and reserves
Measurement errors can occur when attempting to
measure the value of funds transferred into or out of a
country.

International flow of funds


Growth in international trade
Events That Increased Trade Volume
Removal of the Berlin Wall: Led to reductions in
trade barriers in Eastern Europe.
Single European Act of 1987: Improved access to
supplies from firms in other European countries.
North American Free Trade Agreement (NAFTA):
Allowed U.S. firms to penetrate product and labor
markets that previously had not been accessible.
General Agreement on Tariffs and Trade (GATT):
Called for the reduction or elimination of trade
restrictions on specified imported goods over a 10-
year period across 117 countries.

International flow of funds


Growth in international trade
Events That Increased Trade Volume (cont.)
Inception of the Euro: Reduced costs and risks
associated with converting one currency to
another.
Expansion of the European Union: reduced
restrictions on trade with Western Europe.
Other Trade Agreements: The United States
has established trade agreements with many
other countries.

International flow of funds


Growth in international trade
Impact of Outsourcing on Trade
Definition of Outsourcing: The process of
subcontracting to a third party in another country to
provide supplies or services that were previously
produced internally.
Impact of outsourcing:
Increased international trade activity because MNCs now
purchase products or services from another country.
Lower cost of operations and job creation in countries
with low wages.
Criticism of outsourcing:
Outsourcing may reduce jobs in the United States.

International flow of funds


Growth in international trade
Impact of Outsourcing on Trade (cont.)
Managerial decisions about outsourcing
Managers of a U.S.based MNC may argue that
they create jobs for U.S. workers.
Shareholders may suggest that the managers are
not maximizing the MNCs value as a result of their
commitment to creating U.S. jobs.
Managers should consider the potential savings
that could occur as a result of outsourcing.
Managers must also consider the possible bad
publicity or bad morale that could occur among the
U.S. workers.

International flow of funds


Growth in international trade
Trade Volume Among Countries
The annual international trade volume of the United
States is between 10 and 20 percent of its annual
GDP.
Trade volume between the United States and
Other Countries:
About 20 percent of all U.S. exports are to Canada,
while 13 percent are to Mexico. (Exhibits 2.3 and 2.4)
Canada, China, Mexico, and Japan are the key
exporters to the United States. Together, they are
responsible for more than half of the value of all U.S.
imports.

International flow of funds


Exhibit 2.3 Distributions of U.S exports by
country (2010, billions of $)

International flow of funds


Exhibit 2.4 2008 Distribution of U.S
exports and imports by country (2008)

International flow of funds


Growth in international trade
Trend in U.S. Balance of Trade (Exhibit 2.5)
The U.S. balance of trade deficit increased
substantially from 1997 until 2008.
In the 20082009 period, U.S. economic
conditions weakened and the U.S. demand for
foreign products and services decreased.
In recent years, the U.S. annual balance of trade
deficit with China has exceeded $200 billion.
Any countrys balance of trade can change
substantially over time.

International flow of funds


Exhibit 2.5 U.S balance of trade over time
(quarterly)

International flow of funds


Factors affecting international trade flows
Cost of Labor: Firms in countries where labor
costs are low commonly have an advantage when
competing globally, especially in labor intensive
industries
Inflation: Current account decreases if inflation
increases relative to trade partners.
National Income: Current account decreases if
national income increases relative to other
countries.
Credit Conditions: tend to tighten when
economic conditions weaken causing banks to be
less willing to extend financing to MNCs

International flow of funds


Factors affecting international trade flows
Government Policies: can increase imports
through:
Restrictions on imports
Subsidies for exporters
Restrictions on piracy
Environmental restrictions
Labor laws
Business laws
Tax breaks
Country security laws
Government ownership or subsidies
Policies to punish country governments

International flow of funds


Factors affecting international trade flows
Impact of Government Policies (cont.)
Restrictions on Imports: Taxes (tariffs) on imported
goods increase prices and limit consumption. Quotas
limit the volume of imports.
Subsidies for Exporters: Government subsidies help
firms produce at a lower cost than their global
competitors (dumping)
Restrictions on Piracy: A government can affect
international trade flows by its lack of restrictions on
piracy.
Environmental Restrictions: Environmental
restrictions impose higher costs on local firms, placing
them at a global disadvantage compared to firms in
other countries that are not subject to the same
restrictions.

International flow of funds


Factors affecting international trade flows
Impact of Government Policies (cont.)
Labor Laws: countries with more restrictive laws will
incur higher expenses for labor, other factors being
equal.
Business Laws: Firms in countries with more
restrictive bribery laws may not be able to compete
globally in some situations.
Tax Breaks: Though not necessarily a subsidy, but
still a form of government financial support that might
benefit many firms that export products.
Country Trade Requirements: Requiring various
forms or obtaining licenses before countries can
export to the country (Bureaucracy) is a strong trade
barrier.

International flow of funds


Factors affecting international trade flows
Impact of Government Policies (cont.)
Government Ownership or Subsidies: Some
governments maintain ownership in firms that are
major exporters.
Country Security Laws: Governments may impose
certain restrictions when national security is a
concern, which can affect on trade.
Policies to Punish Country Governments: Many
expect countries to restrict imports from countries
that
Fail to enforce environmental laws and child labor laws
Initiate war against another country
Unwilling to participate in a war

International flow of funds


Factors affecting international trade flows

Impact of Government Policies (cont.)


Summary of Government Policies:
Every government implements some policies
No formula ensure a completely fair contest for
market share

International flow of funds


Factors affecting international trade flows

Exchange Rates: current account decreases if


currency appreciates relative to other currencies.
How exchange rates may correct a balance of trade
deficit:
When a home currency is exchanged for a foreign
currency to buy foreign goods, then the home currency
faces downward pressure, leading to increased foreign
demand for the countrys products.
Why exchange rates may not correct a balance of
trade deficit:
Exchange rates will not automatically correct any
international trade balances when other forces are at work.

International flow of funds


Factors affecting international trade flows

International flow of funds


Factors affecting international trade flows
Exchange Rates (cont.)
Limitations of a Weak Home Currency Solution
Competition: foreign companies may lower their prices
to remain competitive.
Impact of other currencies: a country that has balance
of trade deficit with many countries is not likely to solve
all deficits simultaneously.
Prearranged international trade transactions:
international transactions cannot be adjusted
immediately. The lag is estimated to be 18 months or
longer, leading to a J-curve effect. (Exhibit 2.6)
Intracompany trade: Many firms purchase products that
are produced by their subsidiaries. These transactions
are not necessarily affected by currency fluctuations.

International flow of funds


Exhibit 2.6 J-Curve effect

International flow of funds


Factors affecting international trade flows

Exchange Rates (cont.)


Exchange Rates and International Friction
All governments cannot weaken their home
currencies simultaneously.
Actions by one government to weaken its currency
causes another countrys currency to strengthen.
Government attempts to influence exchange rates
can lead to international disputes.

International flow of funds


International capital flows
Factors Affecting Direct Foreign
Investment
Changes in Restrictions
New opportunities have arisen from the removal of
government barriers.
Privatization
DFI is stimulated by new business opportunities
associated with privatization.
Managers of privately owned businesses are
motivated to ensure profitability, further stimulating
DFI.

International flow of funds


International capital flows
Factors Affecting Direct Foreign
Investment (Cont.)
Potential Economic Growth
Countries with greater potential for economic
growth are more likely to attract DFI.
Tax Rates
Countries that impose relatively low tax rates on
corporate earnings are more likely to attract DFI.
Exchange Rates
Firms typically prefer to pursue DFI in countries
where the local currency is expected to strengthen
against their own.

International flow of funds


International capital flows
Factors Affecting International Portfolio
Investment
Tax Rates on Interest or Dividends
Investors normally prefer to invest in a country
where taxes are relatively low.
Interest Rates
Money tends to flow to countries with high interest
rates, as long as the local currencies are not
expected to weaken.
Exchange Rates
Investors are attracted to a currency that is
expected to strengthen.

International flow of funds


International capital flows
Impact of International Capital Flows (Exhibit
2.7)
The United States relies heavily on foreign investment
in:
U.S. manufacturing plants, offices, and other buildings.
Debt securities issued by U.S. firms.
U.S. Treasury debt securities
Foreign investors are especially attracted to the U.S.
financial markets when the interest rate in their home
country is substantially lower than that in the United
States.
U.S. reliance on foreign funds: In general, access
to international funding has allowed more growth in
the U.S. economy over time but has also made the
U.S. more reliant on foreign investors.

International flow of funds


Exhibit 2.7 Impact of the international flow of funds
on U.S interest rates and business investment

International flow of funds


Agencies that facilitate international flows
International Monetary Fund
Major Objectives of the IMF
promote cooperation among countries on international
monetary issues,
promote stability in exchange rates
provide temporary funds to member countries
attempting to correct imbalances of international
payments
promote free mobility of capital funds across countries
promote free trade. It is clear from these objectives
that the IMFs goals encourage increased
internationalization of business
Its compensatory financing facility (CFF) attempts
to reduce the impact of export instability on countries.
Financing is measured in special drawing rights
(SDRs)

International flow of funds


Agencies that facilitate international flows

World Bank - (International Bank for


Reconstruction and Development)
Major Objective- Make loans to countries to enhance
economic development.
Structural Adjustment Loans (SALs) are intended
to enhance a countrys long-term economic growth.
Funds are distributed through co financing
agreements:
Official aid agencies
Export credit agencies
Commercial banks

International flow of funds


Agencies that facilitate international flows

World Trade Organization (WTO)


Major Objective - Provide a forum for multilateral
trade negotiations and to settle trade disputes
related to the GATT accord.
Member countries are given voting rights that are
used to make judgments about trade disputes
and other issues.

International flow of funds


Agencies that facilitate international flows
International Financial Corporation (IFC)
Major Objective - promote private enterprise
within countries.
Provides loans to corporations and purchases
stock
It traditionally has obtained financing from the
World Bank but can borrow in the international
financial markets.
International Development Association (IDA)
Major Objectives - extends loans at low interest
rates to poor nations that cannot qualify for loans
from the World Bank.

International flow of funds


Agencies that facilitate international flows

Bank for International Settlements (BIS)


Major Objectives - facilitate cooperation among
countries with regard to international
transactions.
Provides assistance to countries experiencing a
financial crisis.
Sometimes referred to as the central banks
central bank or the lender of last resort.

International flow of funds


Agencies that facilitate international flows

OECD - Organization for Economic


Cooperation and Development
Major Objective - Facilitate governance in
governments and corporations of countries with
market economics.
It has 30 member countries and has relationships
with numerous countries.
Promotes international country relationships that
lead to globalization.

International flow of funds


Agencies that facilitate international flows
Regional Development Agencies
Inter-American Development Bank: focusing on
the needs of Latin America
Asian Development Bank: established to enhance
social and economic development in Asia
African Development Bank: focusing on
development in African countries
European Bank for Reconstruction and
Development: created in 1990 to help the
Eastern European countries adjust from
communism to capitalism.

International flow of funds


Summary
The key components of the balance of payments
are the current account and the capital account.
Current account - broad measure of the
countrys international trade balance. Capital
account - measure of the countrys long-term and
short-term capital investments.
International trade activity has grown over time.
Outsourcing, subcontracting with a third party in
a foreign country for supplies or services they
previously produced themselves, has increased.
Thus increasing international trade activity.
A countrys international trade flows are affected
by inflation, national income, government
restrictions, and exchange rates.

International flow of funds


Summary
A countrys international capital flows are affected by
any factors that influence direct foreign investment or
portfolio investment. Direct foreign investment tends
to occur in those countries that have no restrictions
and much potential for economic growth. Portfolio
investment tends to occur in those countries where
taxes are not excessive, where interest rates are high,
and where the local currencies are not expected to
weaken.
Several agencies facilitate the international flow of
funds by promoting international trade and finance,
providing loans to enhance global economic
development, settling trade disputes between
countries, and promoting global business relationships
between countries.

International flow of funds


Thank you for your attention

International flow of funds


International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 3- International Financial Markets

Dr. Vassilios Papavassiliou


Business eLearning
Chapter objectives
Describe the background and corporate use of the
following International Financial Markets:
Foreign exchange market

International money market

International credit market

International bond market

International stock markets

International financial markets


Foreign exchange market
Allows for the exchange of one currency for
another.
Exchange rate specifies the rate at which one
currency can be exchanged for another.

International financial markets


Foreign exchange market
History of Foreign Exchange
Gold Standard (1876 1913)
Each currency was convertible into gold at a
specified rate. When World War I began in 1914,
the gold standard was suspended.
Agreements on Fixed Exchange Rates
Bretton Woods Agreement 1944 - 1971
Smithsonian Agreement 1971 - 1973
Floating Exchange Rate System
Widely traded currencies were allowed to fluctuate
in accordance with market forces

International financial markets


Foreign exchange market
Foreign Exchange Transactions
The over-the-counter market is the
telecommunications network where companies
normally exchange one currency for another.
Foreign exchange dealers serve as
intermediaries in the foreign exchange market
Spot Market: A foreign exchange transaction for
immediate exchange is said to trade in the spot
market. The exchange rate in the spot market is
the spot rate.
Spot Market Structure: Trading between banks
occurs in the interbank market.

International financial markets


Foreign exchange market
Foreign Exchange Transactions (cont.)
Use of the U.S. dollar in spot markets: The
U.S. Dollar is the commonly accepted medium of
exchange in the spot market.
Spot market time zones - Foreign exchange
trading is conducted only during normal business
hours in a given location. Thus, at any given time
on a weekday, somewhere around the world a
bank is open and ready to accommodate foreign
exchange requests.
Spot market liquidity: More buyers and sellers
means more liquidity.

International financial markets


Foreign exchange market
Foreign Exchange Transactions (cont.)
Attributes of Banks That Provide Foreign
Exchange
Competitiveness of quote
Special relationship with the bank
Speed of execution
Advice about current market conditions
Forecasting advice

International financial markets


Foreign exchange market
Foreign Exchange Quotations
At any given point in time, a banks bid (buy) quote
for a foreign currency will be less than its ask (sell)
quote.
Bid/Ask spread of banks: The bid/ask spread
covers the banks cost of conducting foreign exchange
transactions
Comparison of Bid/Ask spread among currencies
(Exhibit 3.1)

Ask rate Bid rate


Bid / ask spread
Ask rate

International financial markets


Exhibit 3.1 Computation of the bid-ask spread

International financial markets


Foreign exchange market
Foreign Exchange Quotations (cont.)
Factors That Affect the Spread
Order costs: Costs of processing orders, including
clearing costs and the costs of recording transactions.
Inventory costs: Costs of maintaining an inventory of
a particular currency.
Competition: The more intense the competition, the
smaller the spread quoted by intermediaries.
Volume: Currencies that have a large trading volume
are more liquid because there are numerous buyers and
sellers at any given time.
Currency risk: Economic or political conditions that
cause the demand for and supply of the currency to
change abruptly.

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations
Direct versus indirect quotations at one
point in time (Exhibit 3.2)
Direct Quotation represents the value of a foreign
currency in dollars (number of dollars per
currency).
Example: $1.40 per Euro

Indirect quotation represents the number of


units of a foreign currency per dollar.
Example: 0.7143 per Dollar

Indirect quotation = 1 / Direct quotation

International financial markets


Exhibit 3.2 Direct & indirect exchange rate
quotations

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations
(cont.)
Direct versus indirect exchange rate over
time (Exhibit 3.3)
When the euro is appreciating against the dollar
(based on an upward movement of the direct
exchange rate of the euro), the indirect exchange
rate of the euro is declining.

When the euro is depreciating (based on a


downward movement of the direct exchange rate)
against the dollar, the indirect exchange rate is
rising.

International financial markets


Exhibit 3.3 Relationship over time between
the Euros direct and indirect exchange rates

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations
(cont.)
Source of exchange rate quotations
Updated currency quotations are provided for
several major currencies on Yahoos website
(finance.yahoo.com/currency).

Exchange rate quotations are also provided by


many other online sources, including oanda.com.

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations (cont.)
Cross Exchange Rates
Cross exchange rate is the amount of one foreign
currency per unit of another foreign currency
Example
Value of peso = $0.07
Value of Canadian dollar = $0.70
Value of peso in C$ = Value of peso in $
Value of C$ in $
= $0.07 = C$ 0.10
$0.70
Source of cross exchange rate quotations: Cross
exchange rates are provided for several major currencies
on Yahoos website (finance.yahoo.com/currency-investing).

International financial markets


Foreign exchange market

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations
(cont.)
Currency Derivatives: A contract with a price that is
partially derived from the value of the underlying
currency that it represents.
Forward Contracts: agreements between a foreign
exchange dealer and an MNC that specifies the
currencies to be exchanged, the exchange rate, and
the date at which the transaction will occur.
The forward rate is the exchange rate specified by the
forward contract.
The forward market is the over-the-counter market
where forward contracts are traded.

International financial markets


Foreign exchange market
Interpreting Foreign Exchange Quotations
(cont.)
Currency futures contracts: similar to forward
contracts but sold on an exchange

Specifies a standard volume of a particular currency to


be exchanged on a specific settlement date.

The futures rate is the exchange rate at which one can


purchase or sell a specified currency on the specified
settlement date.

The future spot rate is the spot rate that will exist at a
future point in time and is uncertain as of today.

International financial markets


Currency derivatives
Interpreting Foreign Exchange Quotations
(cont.)
Currency Options Contracts
Currency Call Option: provides the right to buy
currency at a specified strike price within a
specified period of time.

Currency Put Option: provides the right to sell


currency at specified strike price within a specified
period of time.

International financial markets


International money market
Corporations or governments need short-term
funds denominated in a currency different from
their home currency.
The international money market has grown because
firms:
May need to borrow funds to pay for imports
denominated in a foreign currency.
May choose to borrow in a currency in which the
interest rate is lower.
May choose to borrow in a currency that is expected to
depreciate against their home currency

International financial markets


International money market
Origins and Development
European Money Market: Dollar deposits in
banks in Europe and other continents are called
Eurodollars or Eurocurrency. Origins of the
European money market can be traced to the
Eurocurrency market that developed during the
1960s and 1970s.

Asian Money Market: Centered in Hong Kong


and Singapore. Originated as a market involving
mostly dollar-denominated deposits, and was
originally known as the Asian dollar market.

International financial markets


International money market
Money Market Interest Rates Among
Currencies

The money market interest rates in any particular


country are dependent on the demand for short-
term funds by borrowers, relative to the supply of
available short-term funds that are provided by
savers. (Exhibit 3.4)

Money market rates vary due to differences in


the interaction of the total supply of short-term
funds available (bank deposits) in a specific
country versus the total demand for short-term
funds by borrowers in that country.

International financial markets


Exhibit 3.4 Comparison of 2011
international money market interest rates

International financial markets


International money market
Money Market Interest Rates Among
Currencies (cont.)
Global Integration of Money Market Interest
Rates
Money market interest rates among countries tend to be
highly correlated over time.
When economic conditions weaken, the corporate
need for liquidity declines, and corporations reduce the
amount of short term funds they wish to borrow.
When economic conditions strengthen, there is an
increase in corporate expansion, and corporations need
additional liquidity to support their expansion.

International financial markets


Risk of international money market securities
Money Market Interest Rates Among
Currencies (cont.)
Risk of International Money Market Securities
International Money Market Securities are debt
securities issued by MNCs and government agencies
with a short-term maturity (1 year or less)
Normally, these securities are perceived to be very safe
from the risk of default.
Even if the international money market securities are
not exposed to credit risk, they are exposed to
exchange rate risk when the currency denominating
the securities differs from the home currency of the
investors.

International financial markets


International credit market
MNCs sometimes obtain medium-term funds
through term loans from local financial
institutions or through the issuance of notes
(medium-term debt obligations) in their local
markets.
Loans of 1 year or longer extended by banks to
MNCs or government agencies in Europe are
commonly called Eurocredits or Eurocredit
loans.
To avoid interest rate risk, banks commonly use
floating rate loans with rates tied to the London
Interbank Offer Rate (LIBOR).

International financial markets


International credit market
Syndicated Loans in the Credit Market

Sometimes a single bank is unwilling or unable to


lend the amount needed by an MNC or
government agency.

A syndicate of banks can be formed to


underwrite the loans and the lead bank is
responsible for negotiating the terms with the
borrower.

International financial markets


International credit market

International financial markets


International credit market
Regulations in the Credit Market
Single European Act
Capital can flow freely throughout Europe.
Banks can offer a wide variety of lending, leasing,
and securities activities in the EU.
Regulations regarding competition, mergers, and
taxes are similar throughout the EU.
A bank established in any one of the EU countries
has the right to expand into any or all of the other
EU countries.

Basel Accord - Banks must maintain capital equal


to at least 4 percent of their assets. For this purpose,
banks assets are weighted by risk.

International financial markets


International credit market
Regulations in the Credit Market (Cont.)

Basel II Accord - Attempts to account for differences


in collateral among banks. In addition, this accord
encourages banks to improve their techniques for
controlling operational risk, which could reduce
failures in the banking system. Also plans to require
banks to provide more information to existing and
prospective shareholders about their exposure to
different types of risk.

Basel III Accord - Called for new methods of


estimating risk-weighted assets that would increase
the level of risk-weighted assets, and therefore
require banks to maintain higher levels of capital.

International financial markets


International credit market

International financial markets


International credit market
Impact of the Credit Crisis on the Credit
Market

The credit crisis of 2008 triggered by defaults in


subprime loans led to a halt in housing
development, which reduced income, spending,
and jobs.

Financial institutions became cautious with their


funds and were less willing to lend funds to MNCs

International financial markets


International bond market
Foreign bonds are issued by borrower foreign
to the country where the bond is placed.
Eurobonds
Features of Eurobonds
Bearer bonds
Annual coupon payments
Convertible or callable
Denominations of Eurobonds
commonly denominated in a number of currencies

International financial markets


International bond market
Eurobonds (cont.)
Underwriting Process
multinational syndicate; simultaneously placed in
many countries
Secondary Market
market makers are in many cases the same
underwriters who sell the primary issues
Impact of the Euro on the Eurobond Market
Before the euros adoption, many countries issued
bonds denominated in their local currency.
With many bonds issued in euro denominations,
the market is much larger and more liquid.

International financial markets


International bond market
Development of Other Bond Markets
Bond markets have developed in Asia and South
America
Bond market yields among countries tend to be
highly correlated over time.
When economic conditions weaken, aggregate
demand for funds declines with the decline in
corporate expansion.
When economic conditions strengthen,
aggregate demand for funds increases with the
increase in corporate expansion.

International financial markets


International bond market
Risk of International Bonds
Interest Rate Risk - potential for the value of
bonds to decline in response to rising long-term
interest rates.
Exchange Rate Risk - represents the potential
for the value of bonds to decline (from the
investors perspective) because the currency
denominating the bond depreciates against the
home currency.
Liquidity Risk - represents the potential for the
value of bonds to decline because there is not a
consistently active market for the bonds.
Credit Risk - represents the potential for default.

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International bond market
Impact of the Greek Crisis on Bonds
Spring 2010: Greece experienced weak economic
conditions and large increase in the government
budget deficit.
Concern spread to other European countries such as
Spain, Portugal, and Ireland that had large budget
deficits.
May 2010: many European countries and the IMF
agreed to provide Greece with new loans.
Contagion Effects:
Weakened some other European countries
Forced creditors to recognize that government debt is
not always risk free

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International bond market

International financial markets


International stock markets
Issuance of Stock in Foreign Markets - Some
U.S. firms issue stock in foreign markets to enhance
their global image.
Impact of the Euro: resulted in more stock
offerings in Europe by U.S. and European based
MNCs.
Issuance of Foreign Stock in the U.S.
Yankee stock offerings - Non-U.S. corporations
that need large amounts of funds sometimes issue
stock in the United States
American Depository Receipts (ADR) -
Certificates representing bundles of stock. ADR
shares can be traded just like shares of a stock.

International financial markets


International stock markets

International financial markets


International stock markets
Non-U.S. Firms Listing on U.S. Exchanges

Non-U.S. firms have their shares listed on the


New York Stock Exchange or the Nasdaq market
so that the shares can easily be traded in the
secondary market.

Effect of Sarbanes-Oxley Act on Foreign


Stock Listings - Many non-U.S. firms decided to
place new issues of their stock in the United
Kingdom instead of in the United States so that
they would not have to comply with the law.

International financial markets


International stock markets
Investing in Foreign Stock Markets
Many investors purchase stocks outside of the
home country.
Recently, firms outside the U.S. have been
issuing stock more frequently.
Comparing the size of stock markets (Exhibit 3.5)

International financial markets


Exhibit 3.5 Comparison of stock exchanges
(2013)

International financial markets


International stock markets
How Market Characteristics Vary among
Countries
(Exhibit 3.6)
Stock market participation and trading activity are
higher in countries where managers are encouraged
to make decisions that serve shareholder interests,
and where there is greater transparency.
Factors that influence trading activity:
Rights - vary by country
Legal protection of shareholders
Government enforcement of securities laws
Accounting laws

International financial markets


Exhibit 3.6 Impact of governance on stock
market participation & trading activity

International financial markets


International stock markets
Integration of Stock Markets
Stock market conditions reflect the host countrys
conditions. If the country is integrated, the stock
market will be also.
Integration of International Stock Markets
and Credit Markets
The key link is the risk premium, which affects
the rate of return required by financial
institutions.

International financial markets


How financial markets serve MNCs (exhibit 3.7)

Corporate functions that require foreign


exchange markets.
Foreign trade with business clients.
Direct foreign investment, or the acquisition of
foreign real assets.
Short-term investment or financing in foreign
securities.
Longer-term financing in the international
bond or stock markets.

International financial markets


Exhibit 3.7 Foreign cash flow chart of an MNC

International financial markets


Summary
The foreign exchange market allows currencies to
be exchanged in order to facilitate international
trade or financial transactions. Commercial banks
serve as financial intermediaries in this market.
The international money markets are composed
of several large banks that accept deposits and
provide short-term loans in various currencies.
This market is used primarily by governments
and large corporations.
The international credit markets are composed of
the same commercial banks that serve the
international money market. These banks convert
some of the deposits received into loans (for
medium-term periods) to governments and large
corporations.

International financial markets


Summary

The international bond markets facilitate


international transfers of long-term credit,
thereby enabling governments and large
corporations to borrow funds from various
countries. The international bond market is
facilitated by multinational syndicates of
investment banks that help to place the bonds.
International stock markets enable firms to
obtain equity financing in foreign countries. Thus,
these markets help MNCs finance their
international expansion.

International financial markets


Thank you for your attention

International financial markets


International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 4- Exchange rate determination

Dr. Vassilios Papavassiliou


Business eLearning
Chapter objectives
Explain how exchange rate movements are
measured.
Explain how the equilibrium exchange rate is
determined.
Examine factors that determine the equilibrium
exchange rate.
Explain the movement in cross exchange rates.
Explain how financial institutions attempt to
capitalize on anticipated exchange rate
movements.

Exchange rate determination


Measuring exchange rate movements
Depreciation: decline in a currencys value
Appreciation: increase in a currencys value

Comparing foreign currency spot rates over two


points in time, S and St-1

S St 1
Percent in foreign currency value
St 1

A positive percent change indicates that the


currency has appreciated. A negative percent
change indicates that it has depreciated. (Exhibit
4.1)

Exchange rate determination


Exhibit 4.1 How exchange rate movements
and volatility are measured

Exchange rate determination


Volatility measurements
In statistics, the standard deviation (SD, also represented by the
Greek letter sigma or s) is a measure that is used to quantify
the amount of variation or dispersion of a set of data values. A
standard deviation close to 0 indicates that the data points tend to
be very close to the mean (also called the expected value) of the
set, while a high standard deviation indicates that the data points
are spread out over a wider range of values

Exchange rate determination


Exchange rate equilibrium
The exchange rate represents the price of a
currency, or the rate at which one currency can
be exchanged for another.
Demand for a currency increases when the
value of the currency decreases, leading to a
downward sloping demand schedule. (See Exhibit
4.2)
Supply of a currency for sale increases when
the value of the currency increases, leading to an
upward sloping supply schedule. (See Exhibit
4.3)
Equilibrium equates the quantity of pounds
demanded with the supply of pounds for sale.
(See Exhibit 4.4)

Exchange rate determination


Exhibit 4.2 Demand schedule for British
pounds

Exchange rate determination


Exhibit 4.3 Supply schedule of British
pounds for sale

Exchange rate determination


Exhibit 4.4 Equilibrium exchange rate
determination

Exchange rate determination


Exchange rate equilibrium
Change in the Equilibrium Exchange Rate
Increase in demand schedule: Banks will increase the
exchange to the level at which the amount demanded is
equal to the amount supplied in the foreign exchange
market.
Decrease in demand schedule: Banks will reduce the
exchange to the level at which the amount demanded is
equal to the amount supplied in the foreign exchange
market.
Increase in supply schedule: Banks will reduce the
exchange to the level at which the amount demanded is
equal to the amount supplied in the foreign exchange
market.
Decrease in supply schedule: Banks will increase the
exchange to the level at which the amount demanded is
equal to the amount supplied in the foreign exchange
market.

Exchange rate determination


Factors that influence exchange rates
The equilibrium exchange rate will change over time as supply and
demand schedules change.

Exchange rate determination


Factors that influence exchange rates
Relative Inflation Rates: Increase in U.S. inflation
leads to increase in U.S. demand for foreign goods, an
increase in U.S. demand for foreign currency, and an
increase in the exchange rate for the foreign currency.
(See Exhibit 4.5)
Relative Interest Rates: Increase in U.S. rates leads
to increase in demand for U.S. deposits and a decrease
in demand for foreign deposits, leading to a increase in
demand for dollars and an increased exchange rate for
the dollar. (See Exhibit 4.6)
Real Interest Rates
Fisher Effect:

Real interest rate Nominal interest rate Inflation rate

Exchange rate determination


Exhibit 4.5 Impact of rising U.S inflation on
the equilibrium value of the British pound

Exchange rate determination


Exhibit 4.6 Impact of rising U.S interest rates
on the equilibrium value of the British pound

Exchange rate determination


Factors that influence exchange rates
Relative Income Levels: Increase in U.S. income
leads to increased demand in U.S. for foreign
goods and increased demand for foreign currency
relative to the dollar and an increase in the
exchange rate for the foreign currency. (See Exhibit
4.7)

Government Controls via:


Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as inflation,
interest rates, and income levels.

Exchange rate determination


Exhibit 4.7 Impact of rising U.S income levels
on equilibrium value of the British pound

Exchange rate determination


Factors that influence exchange rates
Expectations:
Impact of favorable expectations: If investors
expect interest rates in one country to rise, they
may invest in that country leading to a rise in the
demand for foreign currency and an increase in
the exchange rate for foreign currency.
Impact of unfavorable expectations:
Speculators can place downward pressure on a
currency when they expect it to depreciate.
Impact of signals on currency speculation.
Speculators may overreact to signals causing
currency to be temporarily overvalued or
undervalued.

Exchange rate determination


Factors that influence exchange rates
Interaction of Factors: some factors place
upward pressure while other factors place
downward pressure. (See Exhibit 4.8)
Influence of Factors across Multiple
Currency Markets: common for European
currencies to move in the same direction against
the dollar.
Influence of Liquidity on Exchange Rate
adjustment: If a currencys spot market is liquid
then its exchange rate will not be highly sensitive
to a single large purchase or sale.

Exchange rate determination


Exhibit 4.8 Summary of how factors affect
exchange rates

Exchange rate determination


Movements in cross exchange rates
If currencies A and B move in same direction,
there is no change in the cross exchange rate.
When currency A appreciates against the dollar
by a greater (smaller) degree than currency B,
then currency A appreciates (depreciates) against
B.
When currency A appreciates (depreciates)
against the dollar, while currency B is unchanged
against the dollar, currency A appreciates
(depreciates) against currency B by the same
degree as it appreciates (depreciates) against the
dollar.

Exchange rate determination


Movements in cross exchange rates
Explaining Movements in Cross Exchange Rate.
Changes are affected in the same way as types of
forces explained earlier for those that affect
demand and supply conditions between two
currencies.

Exchange rate determination


Exhibit 4.9 Example of how forces affect the
cross exchange rate

Exchange rate determination


Capitalizing on expected exchange rate
movements
Institutional speculation based on expected
appreciation - When financial institutions
believe that a currency is valued lower than it
should be in the foreign exchange market, they
may invest in that currency before it appreciates.
Institutional speculation based on expected
depreciation - If financial institutions believe
that a currency is valued higher than it should be
in the foreign exchange market, they may borrow
funds in that currency and convert it to their local
currency now before the currencys value declines
to its proper level.
Speculation by individuals Individuals can
speculate in foreign currencies.

Exchange rate determination


Capitalizing on expected exchange rate
movements

Exchange rate determination


Capitalizing on expected exchange rate
movements

Exchange rate determination


Capitalizing on expected exchange rate
movements

Exchange rate determination


Capitalizing on expected exchange rate
movements
The Carry Trade Where investors attempt to
capitalize on the differential in interest rates
between two countries.
Impact of appreciation in the investment
currency: Increased trade volume can have a
major influence on exchange rate movements
over a short period.
Risk of the Carry Trade: Exchange rates may
move opposite to what the investors expected.

Exchange rate determination


Capitalizing on expected exchange rate
movements

Exchange rate determination


Capitalizing on expected exchange rate
movements

Exchange rate determination


Summary
Exchange rate movements are commonly
measured by the percentage change in their
values over a specified period, such as a month
or a year. MNCs closely monitor exchange rate
movements over the period in which they have
cash flows denominated in the foreign currencies
of concern.
The equilibrium exchange rate between two
currencies at any time is based on the demand
and supply conditions. Changes in the demand
for a currency or the supply of a currency for sale
will affect the equilibrium exchange rate.

Exchange rate determination


Summary
The key economic factors that can influence exchange
rate movements through their effects on demand and
supply conditions are relative inflation rates, interest
rates, and income levels, and government controls.
When these factors lead to a change in international
trade or financial flows, they affect the demand for a
currency or the supply of currency for sale and thus
the equilibrium exchange rate.
There are distinct international trade and financial
flows between every pair of countries. These flows
dictate the unique supply and demand conditions for
the currencies of the two countries, which affect the
equilibrium cross exchange rate between their
currencies. Movement in the exchange rate between
two non-dollar currencies can be inferred from the
movement in each currency against the dollar.

Exchange rate determination


Summary
Financial institutions can attempt to benefit from the
expected appreciation of a currency by purchasing
that currency. Analogously, they can benefit from
expected depreciation of a currency by borrowing that
currency and exchanging it for their home currency.

Exchange rate determination


Thank you for your attention

Exchange rate determination


International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 5- Currency derivatives

Dr. Vassilios Papavassiliou


Business eLearning
Chapter objectives
Explain how forward contracts are used to
hedge based on anticipated exchange rate
movements
Describe how currency futures contracts are
used to speculate or hedge based on
anticipated exchange rate movements
Explain how currency option contracts are
used to speculate or hedge based on
anticipated exchange rate movements

Currency derivatives
What is a currency derivative?
A currency derivative is a contract whose price
is derived from the value of an underlying
currency.
Examples include forwards/futures contracts
and options contracts.
Derivatives are used by MNCs to:
Speculate on future exchange rate movements
Hedge exposure to exchange rate risk

Currency derivatives
Forward market
A forward contract is an agreement between a
corporation and a financial institution:
To exchange a specified amount of currency
At a specified exchange rate called the
forward rate
On a specified date in the future

Currency derivatives
Forward market

Currency derivatives
Forward market
How MNCs Use Forward Contracts
Hedge their imports by locking in the rate at
which they can obtain the currency
Bank Quotations on Forward Rates
Bid/Ask Spread is wider for less liquid
currencies.
May negotiate an offsetting trade if an MNC
enters into a forward sale and a forward purchase
with the same bank.

Currency derivatives
Forward market
Premium or Discount on the Forward Rate
(Exhibit 5.1)
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by
which the forward rate exceeds the spot rate.

Arbitrage If the forward rate was the same as


the spot rate, arbitrage would be possible.

Currency derivatives
Forward market

Currency derivatives
Forward market

Currency derivatives
Exhibit 5.1 Computation of forward rate
premiums or discounts

Currency derivatives
Forward market
Movements in the Forward Rate over Time The
forward premium is influenced by the interest rate
differential between the two countries and can change
over time.
Offsetting a Forward Contract An MNC can offset
a forward contract by negotiating with the original
counterparty bank.
Using Forward Contracts for Swap Transactions
- involves a spot transaction along with a
corresponding forward contract that will ultimately
reverse the spot transaction.
Non-deliverable forward contracts (NDF) - can be
used for emerging market currencies where no
currency delivery takes place at settlement; instead
one party makes a payment to the other party.

Currency derivatives
Forward market

Currency derivatives
Forward market

Currency derivatives
Currency futures market
Similar to forward contracts in terms of obligation
to purchase or sell currency on a specific settlement
date in the future.
Contract Specifications: Differ from forward
contracts because futures have standard contract
specifications:
Standardized number of units per contract
(See Exhibit 5.2)
Offer greater liquidity than forward contracts
Typically based on U.S. dollar, but may be
offered on cross-rates.
Commonly traded on the Chicago Mercantile
Exchange (CME).

Currency derivatives
Exhibit 5.2 Currency futures contracts
traded on the Chicago Mercantile Exchange

Currency derivatives
Currency futures market
Trading Currency Futures
Firms or individuals can execute orders for
currency futures contracts by calling brokerage
firms.
Trading platforms for currency futures:
Electronic trading platforms facilitate the trading
of currency futures. These platforms serve as a
broker, as they execute the trades desired.
Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in
the exchange rate at which a specific currency is
purchased or sold for a specific date in the future.

Currency derivatives
Exhibit 5.3 Comparison of the forward and
futures market

Currency derivatives
Currency futures market
Comparing Futures to Forward Contracts
Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in
the exchange rate at which a specific currency is
purchased or sold for a specific date in the future.
(Exhibit 5.3)
Pricing Currency Futures - The price of
currency futures will be similar to the forward
rate
Credit Risk of Currency Futures Contracts - To
minimize its risk, the CME imposes margin
requirements to cover fluctuations in the value of a
contract, meaning that the participants must make
a deposit with their respective brokerage firms
when they take a position.

Currency derivatives
Currency futures market
How Firms Use Currency Futures
Purchasing Futures to Hedge Payables - The
purchase of futures contracts locks in the price at
which a firm can purchase a currency.
Selling Futures to Hedge Receivables - The
sale of futures contracts locks in the price at
which a firm can sell a currency.
Closing Out a Futures Position (Exhibit 5.4)
Sellers (buyers) of currency futures can close out
their positions by buying (selling) identical futures
contracts prior to settlement.
Most currency futures contracts are closed out
before the settlement date.

Currency derivatives
Currency futures market

Currency derivatives
Currency futures market

Currency derivatives
Exhibit 5.4 Closing out a futures contract

Currency derivatives
Currency futures market
Speculation with Currency Futures (Exhibit 5.5)
Currency futures contracts are sometimes
purchased by speculators attempting to capitalize
on their expectation of a currencys future
movement.
Currency futures are often sold by speculators
who expect that the spot rate of a currency will
be less than the rate at which they would be
obligated to sell it.

Currency derivatives
Exhibit 5.5 Source of gains from buying
currency futures

Currency derivatives
Currency futures market
Speculation with Currency Futures (cont.)
Efficiency of the currency futures market
If the currency futures market is efficient, the
futures price should reflect all available
information.
Thus, the continual use of a particular strategy to
take positions in currency futures contracts should
not lead to abnormal profits.
Research has found that the currency futures
market may be inefficient. However, the patterns
are not necessarily observable until after they
occur, which means that it may be difficult to
consistently generate abnormal profits from
speculating in currency futures.

Currency derivatives
Currency options market
Currency options provide the right to purchase or
sell currencies at specified prices.
Options Exchanges
1982 - exchanges in Amsterdam, Montreal, and
Philadelphia first allowed trading in standardized
foreign currency options.
2007 CME and CBOT merged to form CME group
Exchanges are regulated by the SEC in the U.S.
Over-the-counter market - Where currency
options are offered by commercial banks and
brokerage firms. Unlike the currency options traded
on an exchange, the over-the-counter market offers
currency options that are tailored to the specific
needs of the firm.

Currency derivatives
Currency call options
Grants the right to buy a specific currency at a
designated strike price or exercise price within
a specific period of time.
If the spot rate rises above the strike price, the
owner of a call can exercise the right to buy
currency at the strike price.
The buyer of the option pays a premium.
If the spot exchange rate is greater than the
strike price, the option is in the money. If the
spot rate is equal to the strike price, the option is
at the money. If the spot rate is lower than the
strike price, the option is out of the money.

Currency derivatives
Currency call options
Factors Affecting Currency Call Option
Premiums

The premium on a call option (C) is affected by three


factors:
Spot price relative to the strike price (S X): The
higher the spot rate relative to the strike price, the
higher the option price will be.
Length of time before expiration (T): The longer
the time to expiration, the higher the option price will
be.
Potential variability of currency (): The greater the
variability of the currency, the higher the probability
that the spot rate can rise above the strike price.

Currency derivatives
Currency call options
How Firms Use Currency Call Options
Using call options to hedge payables
Using call options to hedge project bidding to
lock in the dollar cost of potential expenses.
Using call options to hedge target bidding of a
possible acquisition.

Currency derivatives
Currency call options
Speculating with Currency Call Options
Individuals may speculate in the currency options
based on their expectations of the future
movements in a particular currency.
Speculators who expect that a foreign currency
will appreciate can purchase call options on that
security.
The net profit to a speculator is based on a
comparison of the selling price of the currency
versus the exercise price paid for the currency
and the premium paid for the call option.

Currency derivatives
Currency call options

Currency derivatives
Currency call options

Currency derivatives
Currency call options
Speculating with Currency Call Options
(cont.)
Break-even point from speculation
Break even if the revenue from selling the currency
equals the payments made for the currency plus
the option premium.
Speculation by MNCs.
Some institutions may have a division that uses
currency options to speculate on future exchange
rate movements
Most MNCs use currency derivatives for hedging
and not speculation.

Currency derivatives
Currency call options

Currency derivatives
Currency put options
Grants the right to sell a currency at a specified
strike price or exercise price within a specified
period of time.
If the spot rate falls below the strike price, the
owner of a put can exercise the right to sell
currency at the strike price.
The buyer of the options pays a premium.
If the spot exchange rate is lower than the strike
price, the option is in the money. If the spot
rate is equal to the strike price, the option is at
the money. If the spot rate is greater than the
strike price, the option is out of the money.

Currency derivatives
Currency put options
Factors Affecting Put Option Premiums

Put option premiums are affected by three factors:


Spot rate relative to the strike price (SX): The
lower the spot rate relative to the strike price, the
higher the probability that the option will be exercised.
Length of time until expiration (T): The longer the
time to expiration, the greater the put option premium
Variability of the currency (): The greater the
variability, the greater the probability that the option
may be exercised.

Currency derivatives
Currency put options
Hedging with Currency Put Options
Corporations with open positions in foreign
currencies can use currency put options in some
cases to cover these positions.
Some put options are deep out of the money,
meaning that the prevailing exchange rate is high
above the exercise price. These options are
cheaper (have a lower premium), as they are
unlikely to be exercised because their exercise
price is too low.
Other put options have an exercise price that is
currently above the prevailing exchange rate and
are therefore more likely to be exercised.
Consequently, these options are more expensive.

Currency derivatives
Currency put options
Speculating with Currency Put Options
Individuals may speculate with currency put options based
on their expectations of the future movements in a
particular currency.
Speculators can attempt to profit from selling currency put
options. The seller of such options is obligated to purchase
the specified currency at the strike price from the owner
who exercises the put option.
The net profit to a speculator is based on the exercise price
at which the currency can be sold versus the purchase price
of the currency and the premium paid for the put option.

Currency derivatives
Currency put options

Currency derivatives
Currency put options
Speculating with Currency Put Options (cont.)
Speculating with combined put and call options
Straddle - uses both a put option and a call option at the
same exercise price
Good for when speculators expect strong movement in
one direction or the other
Efficiency of the currency options market
Research has found that, when transaction costs are
controlled for, the currency options market is efficient.
It is difficult to predict which strategy will generate
abnormal profits in future periods.

Currency derivatives
Currency put options
Contingency graph for the caller of a call option
Compares price paid for the option to the payoffs
received under various exchange rate scenarios.
(Exhibit 5.6)
Contingency graph for the seller of a call option
Compares premium received from selling the option to
the payoffs made to the options buyer under various
exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the buyer of a put option
Compares premium paid for put option to the payoffs
received under various exchange rate scenarios.
(Exhibit 5.6)
Contingency graph for the seller of a put option
Compares premium received for put option to the
payoffs made under various exchange rate scenarios.
(Exhibit 5.6)

Currency derivatives
Exhibit 5.6 Contingency graphs for
currency options

Currency derivatives
Currency put options
European Currency Options
European-style currency options must be
exercised on the expiration date if they are to be
exercised at all.
They do not offer as much flexibility; however,
this is not relevant to some situations.
If European-style options are available for the
same expiration date as American-style options
and can be purchased for a slightly lower
premium, some corporations may prefer them for
hedging.

Currency derivatives
Summary
A forward contract specifies a standard volume of
a particular currency to be exchanged on a
particular date. Such a contract can be purchased
by a firm to hedge payables or sold by a firm to
hedge receivables. A currency futures contract
can be purchased by speculators who expect the
currency to appreciate; it can also be sold by
speculators who expect the currency to
depreciate. If the currency depreciates then the
futures contract declines, allowing those
speculators to benefit when they close out their
positions

Currency derivatives
Summary
Futures contracts on a particular currency can be
purchased by corporations that have payables in
that currency and wish to hedge against the
possible appreciation of that currency.
Conversely, these contracts can be sold by
corporations that have receivables in that
currency and wish to hedge against the possible
depreciation of that currency.

Currency derivatives
Summary
Currency options are classified as call options or
put options. A call option gives its owner the right
to purchase a specified currency at a specified
exchange rate by a specified expiration date.
Likewise, put options give the right to sell a
specified currency at a specified exchange rate by
a specified expiration date.
Call options on a specific currency can be
purchased by speculators who expect the
currency to appreciate. Put options on a specific
currency can be purchased by speculators who
expect that currency to depreciate.

Currency derivatives
Summary
Currency call options are commonly purchased by
corporations that have payables in a currency
that is expected to appreciate. Currency put
options are commonly purchased by corporations
that have receivables in a currency that is
expected to depreciate.

Currency derivatives
Thank you for your attention

Currency derivatives
International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 6- Government influence on exchange
rates
Dr. Vassilios Papavassiliou
Business eLearning
Chapter objectives
Describe the exchange rate system used by
various governments

Describe the development and implications of a


single European currency

Explain how governments can use direct


intervention to influence exchange rates

Explain how government intervention in the


foreign exchange market can affect economic
conditions

Government influence on exchange


rates
Exchange rate systems
Exchange rate systems can be classified according
to the degree of government control and fall into
the following categories:
Fixed
Freely floating
Managed float
Pegged

Government influence on exchange


rates
Exchange rate systems
Fixed Exchange Rate System
Exchange rates are either held constant or
allowed to fluctuate only within very narrow
boundaries.
Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
Central bank can also revalue or increase the
value of its currency against other currencies.

Government influence on exchange


rates
Exchange rate systems
Fixed Exchange Rate System (cont.)
Bretton Woods Agreement 1944 1971 - Each
currency was valued in terms of gold.
Smithsonian Agreement 1971 1973 - called for
a devaluation of the U.S. dollar by about 8 percent
against other currencies.
Advantages of fixed exchange rates
Insulate country from risk of currency appreciation.
Allow firms to engage in direct foreign investment
without currency risk.
Disadvantages of fixed exchange rates
Risk that government will alter value of currency.
Country and MNC may be more vulnerable to
economic conditions in other countries.

Government influence on exchange


rates
Exchange rate systems
Assume that there are two countries only in a
hypothetical setting: US and UK. They trade with each
other under a fixed exchange rate system
If US inflation > UK inflation, US production will be
reduced and the US unemployment rate will rise
The excessive demand for British goods can cause
higher inflation in the UK US exports its
inflation to the UK
A high US unemployment rate will reduce US income
and lead to a decline in US purchases of British goods.
UK productivity will decrease and the unemployment
rate will rise exported unemployment

Government influence on exchange


rates
Exchange rate systems
Freely Floating Exchange Rate System
Exchange rates are determined by market forces
without government intervention.
Advantages of a freely floating system:
Country is more insulated from inflation of other countries.
Country is more insulated from unemployment of other
countries.
Does not require central bank to maintain exchange rates
within specified boundaries.
Disadvantages of a freely floating exchange rate
system:
Can adversely affect a country that has high
unemployment.
Can adversely affect a country with high inflation.

Government influence on exchange


rates
Exchange rate systems

US inflation, demand for UK goods, value of the British pound


UK demand for US goods, supply of British pounds, value of the British pound
UK goods are now more expensive for US consumers. However, in the UK the prices are unchanged

US purchases of UK goods, US demand for British pounds, value of the British pound
British goods are now cheaper for US consumers, offsetting the reduced demand that follows a reduction
in US income

US inflation, US dollar, import prices, US prices of finished goods


US unemployment rate, US demand for imports, dollar value, US imports from the UK

Government influence on exchange


rates
Exchange rate systems
Managed Float Exchange Rate System
Governments sometimes intervene to prevent
their currencies from moving too far in a certain
direction.
Countries with floating exchange rates:
Currencies of most large developed countries are
allowed to float, although they may be
periodically managed by their respective central
banks. (Exhibit 6.1)
Criticisms of the managed float system:
Critics suggest that managed float allows a
government to manipulate exchange rates to
benefit its own country at the expense of others.

Government influence on exchange


rates
Exhibit 6.1 Countries with floating exchange
rates and their currencies

Government influence on exchange


rates
Exchange rate systems
Pegged Exchange Rate System
Home currency value is pegged to one foreign
currency or to an index of currencies.
Limitations of pegged exchange rate
May attract foreign investment because
exchange rate is expected to remain stable.
Weak economic or political conditions can
cause firms and investors to question whether
the peg will be broken.

Government influence on exchange


rates
Exchange rate systems
Pegged Exchange Rate System (cont.)
Examples:
Europes Snake Arrangement 1972 1979
European Monetary System (EMS) 1979 1992
Mexicos Pegged System 1994
Chinas Pegged Exchange Rate 1996 2005
Venezuelas Pegged Exchange Rate 2010

Government influence on exchange


rates
Exhibit 6.2 Countries with pegged exchange rates and
the currencies to which they are pegged

Government influence on exchange


rates
A single European currency
Monetary Policy in the Eurozone
European Central Bank - based in Frankfurt and is
responsible for setting monetary policy for all participating
European countries
Objective is to control inflation in the participating countries
and to stabilize (within reasonable boundaries) the value of
the euro with respect to other major currencies.
Impact on Firms in the Eurozone - Prices of products
are now more comparable among European countries.
Impact on Financial Flows in the Eurozone - Bond
investors who reside in the eurozone can now invest in bonds
issued by governments and corporations in these countries
without concern about exchange rate risk, as long as the bonds
are denominated in euros.

Government influence on exchange


rates
A single European currency
Exposure of Countries within the Eurozone
A single European monetary policy prevents any
individual European country from solving local
economic problems with its own unique
monetary policy.
Any given monetary policy used in the eurozone
during a particular period may enhance
conditions in some countries and adversely
affect others.
Impact of Crises within the Eurozone - may
affect the economic conditions of the other
participating countries because they all rely on the
same currency and same monetary policy.
Government influence on exchange
rates
A single European currency

Government influence on exchange


rates
A single European currency
Impact of Crises within the Eurozone (cont.)
Lessons from Eurozone crisis
Financial problems of one bank can easily spread to
other banks
Banks in Eurozone frequently engage in loan
participations. If companies have trouble repaying, all
banks may be affected.
News about concerns in one area of Eurozone can
trigger actions in other areas.
Eurozone country governments must rely on fiscal policy
when they experience serious financial problems.
Banks lend heavily to governments. Performance is
related to whether that government can repay its debts.

Government influence on exchange


rates
A single European currency

Government influence on exchange


rates
A single European currency
Impact of Crises within the Eurozone
(cont.)
ECB Role in Resolving Economic Crises
In recent years the banks role has expanded
to include providing credit for eurozone
countries that are experiencing a financial
crisis.
The ECB imposes restrictions intended to help
resolve the countrys budget deficit problems
over time.

Government influence on exchange


rates
A single European currency
Between May 2010-June 2011 the ECB
purchased European government bonds
totaling 78 billion. Market analysts estimate
that more than half were Greek bonds.
ECB also provided substantial liquidity
support to private banks in Greece and other
eurozone countries. Liquidity support to Greek
banks climbed from 47 billion in January 2010
to 98 billion in May 2011, roughly 40% of
Greeces 2011 GDP
ECB accepted collateral in its liquidity
operations with lower credit ratings than it did
before the crisis

Government influence on exchange


rates
A single European currency
Banks hold significant amounts of domestic
sovereign bonds on their balance sheets and
these large exposures may easily lead to
valuation losses and solvency concerns when
sovereign yields rise sharply
Sovereign tensions may result in lower
collateral values (e.g. haircuts) which
effectively reduce the ability of banks to obtain
funding
Sovereign downgrades may spill over to
banks, affecting both their access to funding and
its cost, while reducing the funding benefits they
derive from implicit and explicit government
guarantees

Government influence on exchange


rates
A single European currency
The strong interconnection between sovereigns and banks can be gauged by
the correlation between sovereign and bank CDS spreads which strengthened
after the nationalization of Allied Irish Bank in January 2009

Government influence on exchange


rates
A single European currency

Government influence on exchange


rates
A single European currency
Impact on a Country that Abandons the Euro
Would allow a country to set its own exchange
rate to encourage purchasers of exports
Would possibly be expelled from the European
Union which would almost certainly reduce its
trade with other European Union countries.
Impact of Abandoning the Euro on Eurozone
Conditions
Investors may fear other countries abandoning
the euro and reduce investments in the eurozone.
Critics agree that the threat of abandonment
creates more problems than actual abandonment.

Government influence on exchange


rates
A single European currency
The path to debt sustainability in Greece has
been hampered by lack of growth in the
economy due to large-scale austerity measures.
Growth would lower debt and deficit levels as a
percentage of GDP, make investors more inclined
to resume lending and offset the contractionary
effects of fiscal reforms
Europe failed to act decisively during the
crisis and exacerbated investor anxiety rather
than reassured markets
Undoubtedly, the European sovereign debt crisis
has revealed that the fiscal and monetary
policy framework of the EMU is incomplete
and insufficient to prevent a sovereign debt crisis
and correct imbalances

Government influence on exchange


rates
Government intervention
Reasons for Government Intervention
Smoothing exchange rate movements
If a central bank is concerned that its economy will be
affected by abrupt movements in its home currencys
value, it may attempt to smooth the currency
movements over time.
Establishing implicit exchange rate boundaries
Some central banks attempt to maintain their home
currency rates within some unofficial, or implicit,
boundaries.
Responding to temporary disturbances
A central bank may intervene to insulate a currencys
value from a temporary disturbance.

Government influence on exchange


rates
Government intervention

Government influence on exchange


rates
Government intervention
Direct Intervention (Exhibit 6.3)
To force the dollar to depreciate, the Fed can
intervene directly by exchanging dollars that it
holds as reserves for other foreign currencies in
the foreign exchange market.
By flooding the market with dollars in this
manner, the Fed puts downward pressure on the
dollar.
If the Fed desires to strengthen the dollar, it can
exchange foreign currencies for dollars in the
foreign exchange market, thereby putting upward
pressure on the dollar.

Government influence on exchange


rates
Exhibit 6.3 Effects of direct central bank
intervention in the foreign exchange market

Government influence on exchange


rates
Government intervention
Direct Intervention (cont.)
Reliance on reserves
The potential effectiveness of a central banks
direct intervention is the amount of reserves it
can use.
Frequency of Intervention
Number of direct interventions has declined
from 97 different days in 1989 to no more
than 20 days in a year
Coordinated Intervention
Intervention more likely to be effective when it
is coordinated by several central banks.

Government influence on exchange


rates
Government intervention
Direct Intervention (cont.)
Nonsterilized versus sterilized intervention (See
Exhibit 6.4)
When the Fed intervenes in the foreign exchange market
without adjusting for the change in the money supply, it is
engaging in a nonsterilized intervention.
In a sterilized intervention, the Fed intervenes in the
foreign exchange market and simultaneously engages in
offsetting transactions in the Treasury securities markets.
Speculating on direct intervention
Some traders in the foreign exchange market attempt to
determine when Federal Reserve intervention is occurring
and the extent of the intervention in order to capitalize on
the anticipated results of the intervention effort.

Government influence on exchange


rates
Exhibit 6.4 Forms of Central Bank intervention
in the foreign exchange market

Government influence on exchange


rates
Government intervention
Indirect Intervention
The Fed can affect the dollars value indirectly by influencing the
factors that determine it

Government influence on exchange


rates
Indirect intervention
Indirect Intervention (cont.)
Government Control of Interest Rates by
increasing or reducing interest rates
Government Use of Foreign Exchange
Controls such as restrictions on the exchange of
the currency
Intervention Warnings intended to warn
speculators. The announcements could
discourage additional speculation and might
even encourage some speculators to unwind
(liquidate) their existing positions in the
currency.
Government influence on exchange
rates
Indirect intervention

Government influence on exchange


rates
Indirect intervention

Government influence on exchange


rates
Intervention as a policy tool
A weak home currency can stimulate foreign
demand for products. (See Exhibit 6.5)
A strong home currency can encourage
consumers and corporations of that country to
buy goods from other countries. (See Exhibit 6.6)

Government influence on exchange


rates
Exhibit 6.5 How Central Bank intervention
can stimulate the U.S economy

Government influence on exchange


rates
Exhibit 6.6 How Central Bank intervention
can reduce inflation

Government influence on exchange


rates
Summary
Exchange rate systems can be classified as fixed
rate, freely floating, managed float, and pegged.
In a fixed exchange rate system, exchange rates
are either held constant or allowed to fluctuate
only within very narrow boundaries. In a freely
floating exchange rate system, exchange rate
values are determined by market forces without
intervention. In a managed float system,
exchange rates are not restricted by boundaries
but are subject to government intervention. In a
pegged exchange rate system, a currencys value
is pegged to a foreign currency or a unit of
account and moves in line with that currency (or
unit of account) against other currencies.
Government influence on exchange
rates
Summary
Numerous European countries use the euro as
their home currency. The single currency allows
international trade among firms in the eurozone
without foreign exchange expenses and without
concerns about future exchange rate movements.
However, countries that participate in the euro do
not have complete control of their monetary
policy because a single policy is applied to all
countries in the eurozone. In addition, being part
of the eurozone may render some countries more
susceptible to a crisis occurring in some other
eurozone country.

Government influence on exchange


rates
Summary
Governments can use direct intervention by purchasing or
selling currencies in the foreign exchange market, thereby
altering demand and supply conditions and hence the
currencies equilibrium values. When a government
purchases a currency in the foreign exchange market, it
puts upward pressure on that currencys equilibrium value.
When a government sells a currency in the foreign
exchange market, it puts downward pressure on the
currencys equilibrium value.
Governments can use indirect intervention by influencing
the economic factors that affect equilibrium exchange rates.
A common form of indirect intervention is to increase
interest rates in order to attract more international capital
flows, which may cause the local currency to appreciate.
However, indirect intervention is not always effective.

Government influence on exchange


rates
Summary
When the Fed intervenes to weaken the U.S.
dollar, the weaker dollar stimulates the U.S.
economy by reducing U.S. demand for imports
and increasing foreign demand for U.S. exports.
Thus, the weak dollar tends to increase U.S.
employment but can also increase U.S. inflation.
When government intervention strengthens the
U.S. dollar, the stronger dollar increases the U.S.
demand for imports and so intensifies foreign
competition. The strong dollar can reduce U.S.
inflation but may lead to higher levels of U.S.
unemployment.

Government influence on exchange


rates
Thank you for your attention

Government influence on exchange


rates
International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 7- International arbitrage & Interest Rate
Parity
Dr. Vassilios Papavassiliou
Business eLearning
Chapter objectives
Explain the conditions that will result in various
forms of international arbitrage and the
realignments that will occur in response
Explain the concept of interest rate parity
Explain the variation in forward rate premiums
across maturities and over time

International arbitrage & IRP


International arbitrage
Defined as capitalizing on a discrepancy in quoted
prices by making a riskless profit.
Arbitrage will cause prices to realign.
Three forms of arbitrage:
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage

International arbitrage & IRP


International arbitrage
Locational Arbitrage
Defined as the process of buying a currency at
the location where it is priced cheap and
immediately selling it at another location where it
is priced higher. (See Exhibit 7.1)
Gains from locational arbitrage are based on
the amount of money used and the size of the
discrepancy. (See Exhibit 7.2)
Realignment due to locational arbitrage
drives prices to adjust in different locations so as
to eliminate discrepancies.

International arbitrage & IRP


Exhibit 7.1 Currency quotes for locational
arbitrage example

International arbitrage & IRP


Exhibit 7.2 Locational arbitrage

International arbitrage & IRP


International arbitrage

International arbitrage & IRP


International arbitrage
Triangular Arbitrage
Defined as currency transactions in the spot market to
capitalize on discrepancies in the cross exchange rates
between two currencies. (See Exhibits 7.3, 7.4, & 7.5)
Gains from triangular arbitrage: Currency
transactions are conducted in the spot market to
capitalize on the discrepancy in the cross exchange
rate between two countries.
Accounting for the Bid/Ask Spread: Transaction
costs (bid/ask spread) can reduce or even eliminate
the gains from triangular arbitrage.
Realignment due to triangular arbitrage forces
exchange rates back into equilibrium. (See Exhibit
7.6)

International arbitrage & IRP


Exhibit 7.3 Example of triangular arbitrage

International arbitrage & IRP


Exhibit 7.4 Currency quotes for a triangular
arbitrage example with transaction costs

International arbitrage & IRP


Exhibit 7.5 Example of triangular arbitrage
accounting for bid-ask spreads

International arbitrage & IRP


Exhibit 7.6 Impact of triangular arbitrage

International arbitrage & IRP


International arbitrage
Covered Interest Arbitrage
Steps involved in covered interest arbitrage
Defined as the process of capitalizing on the interest
rate differential between two countries while covering
your exchange rate risk with a forward contract.
Consists of two parts: (Exhibit 7.7)
Interest arbitrage: the process of capitalizing on the
difference between interest rates between two
countries.
Covered: hedging the position against interest rate risk.
Realignment due to covered interest arbitrage
causes market realignment.
Timing of realignment may require several
transactions before realignment is completed.

International arbitrage & IRP


International arbitrage

International arbitrage & IRP


Exhibit 7.7 Example of covered interest
arbitrage

International arbitrage & IRP


International arbitrage
Covered Interest Arbitrage (cont.)
Realignment is focused on the forward rate
the forward rate is likely to experience most if not
all of the adjustment needed to achieve
realignment.
Accounting for spreads
Investor must account for the effects of the spread
between the bid and ask quotes and of the spread
between deposit and loan rates.
Covered interest arbitrage by Non-U.S.
investors
The concept of covered interest arbitrage applies to
any two countries for which there is a spot rate and
a forward rate between their currencies as well as
risk-free interest rates quoted for both currencies.

International arbitrage & IRP


International arbitrage

International arbitrage & IRP


International arbitrage

International arbitrage & IRP


International arbitrage
Comparison of Arbitrage Effects (Exhibit 7.8)
The threat of locational arbitrage ensures that
quoted exchange rates are similar across banks
in different locations.
The threat of triangular arbitrage ensures that
cross exchange rates are properly set.
The threat of covered interest arbitrage ensures
that forward exchange rates are properly set. Any
discrepancy will trigger arbitrage, which should
eliminate the discrepancy.
Thus, arbitrage tends to allow for a more orderly
foreign exchange market.

International arbitrage & IRP


Exhibit 7.8 Comparing arbitrage strategies

International arbitrage & IRP


Interest rate parity
In equilibrium, the forward rate differs from the
spot rate by a sufficient amount to offset the
interest rate differential between two currencies.
Derivation of Interest Rate Parity
1 ih
p 1
1 if
where
p forward premium
ih home interest rate
i f foreign interest rate

International arbitrage & IRP


Interest rate parity

International arbitrage & IRP


Interest rate parity
Determining the Forward Premium
Effect of the interest rate differential: The relationship
between the forward premium (or discount) and the interest
rate differential according to IRP is simplified in an
approximated form:
F S
p ih i f
S
where
p forward premium (or discount)
F forward rate in dollars
S spot rate in dollars
ih home interest rate
i f foreign interest rate

Implications: If the forward premium is equal to the interest


rate differential as just described, then covered interest
arbitrage will not be feasible.

International arbitrage & IRP


Interest rate parity

International arbitrage & IRP


Interest rate parity

International arbitrage & IRP


Interest rate parity
Graphic Analysis of Interest Rate Parity
(Exhibit 7.9)
Points representing a discount: points A and B
Points representing a premium: points C and D
Points representing IRP: points A, B, C, D
Points below the IRP line: points X and Y
Investors can engage in covered interest arbitrage and
earn a higher return by investing in foreign currency
after considering foreign interest rate and forward
premium or discount.
Points above the IRP line: point Z
U.S. investors would achieve a lower return on a foreign
investment than on a domestic one.

International arbitrage & IRP


Exhibit 7.9 Comparing arbitrage strategies

International arbitrage & IRP


Interest rate parity
How to Test Whether Interest Rate Parity
Holds
(Exhibit 7.9)
The location of the points provides an indication of
whether covered interest arbitrage is worthwhile.
For points to the right of the IRP line, investors in
the home country should consider using covered
interest arbitrage, since a return higher than the
home interest rate (ih) is achievable.
Of course, as investors and firms take advantage
of such opportunities, the point will tend to move
toward the IRP line.
Covered interest arbitrage should continue until
the interest rate parity relationship holds.

International arbitrage & IRP


Interest rate parity
Interpretation of Interest Rate Parity
Interest rate parity does not imply that investors from
different countries will earn the same returns.
Does Interest Rate Parity Hold?
Compare the forward rate (or discount) with interest
rate quotations occurring at the same time. Due to
limitations in access to data, it is difficult to obtain
quotations that reflect the same point in time.

International arbitrage & IRP


Interest rate parity
Considerations When Assessing Interest Rate
Parity
Transaction costs
The actual point reflecting the interest rate differential
and forward rate premium must be farther from the IRP
line to make covered interest arbitrage worthwhile. (See
Exhibit 7.10)
Political risk
A crisis in the foreign country could cause its
government to restrict any exchange of the local
currency for other currencies.
Differential tax laws
Covered interest arbitrage might be feasible when
considering before-tax returns but not necessarily when
considering after-tax returns.

International arbitrage & IRP


Exhibit 7.10 Potential for covered interest
arbitrage when considering transaction costs

International arbitrage & IRP


Summary
Locational arbitrage may occur if foreign exchange
quotations differ among banks. The act of locational
arbitrage should force the foreign exchange
quotations of banks to become realigned, after which
locational arbitrage will no longer be possible.
Triangular arbitrage is related to cross exchange
rates. A cross exchange rate between two currencies
is determined by the values of these two currencies
with respect to a third currency. If the actual cross
exchange rate of these two currencies differs from the
rate that should exist, triangular arbitrage is possible.
The act of triangular arbitrage should force cross
exchange rates to become realigned, at which time
triangular arbitrage will no longer be possible.

International arbitrage & IRP


Summary
Covered interest arbitrage is based on the relationship
between the forward rate premium and the interest rate
differential. The size of the premium or discount exhibited
by the forward rate of a currency should be about the same
as the differential between the interest rates of the two
countries of concern. In general terms, the forward rate of
the foreign currency will contain a discount (premium) if its
interest rate is higher (lower) than the U.S. interest rate.
If the forward premium deviates substantially from the
interest rate differential, then covered interest arbitrage is
possible. In this type of arbitrage, a short term investment
in some foreign currency is covered by a forward sale of
that foreign currency in the future. In this manner, the
investor is not exposed to fluctuation in the foreign
currencys value.

International arbitrage & IRP


Summary
According to the theory of interest rate parity
(IRP), the size of the forward premium (or
discount) should be equal to the interest rate
differential between the two countries of concern.
If IRP holds then covered interest arbitrage is not
feasible, because any interest rate advantage in
the foreign country will be offset by the discount
on the forward rate. Thus, covered interest
arbitrage would not generate higher returns than
would be generated by a domestic investment.

International arbitrage & IRP


Thank you for your attention

International arbitrage & IRP


International Financial Management (FIN30030)
Academic year 2017-2018, 1st Semester
Lecture 8- Relationships among inflation, interest
rates and exchange rates
Dr. Vassilios Papavassiliou
Business eLearning
Chapter objectives
Explain the purchasing power parity (PPP) theory
and its implications for exchange rate changes

Explain the International Fisher effect (IFE)


theory and its implications for exchange rate
changes

Compare the PPP theory, the IFE theory, and the


theory of interest rate parity (IRP), which was
introduced in the previous chapter

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Interpretations of Purchasing Power Parity
Absolute Form of PPP: without international
barriers, consumers shift their demand to
wherever prices are lower. Prices of the
same basket of products in two different
countries should be equal when measured in
common currency.
Relative Form of PPP: Due to market
imperfections, prices of the same basket of
products in different countries will not
necessarily be the same, but the rate of
change in prices should be similar when
measured in common currency

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Example
Assume that US experiences a 9% inflation rate
while the UK experiences a 5% inflation rate. PPP
suggests that the pound should appreciate by 4%
(the difference between their inflation rates)
Given British inflation of 5% and the pounds
appreciation of 4%, US consumers will have to pay
about 9% more for British goods than they paid
initially. That value is equal to the 9% increase in
prices of US goods due to inflation
The exchange rate should adjust to offset the
differential in their inflation rates, in which case the
prices of goods in the two countries should appear
similar to consumers

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Rational Behind Relative PPP Theory
Exchange rate adjustment is necessary for the
relative purchasing power to be the same
whether buying products locally or from another
country.
If the purchasing power is not equal, consumers
will shift purchases to wherever products are
cheaper until the purchasing power is equal.

Relationships among inflation and rates


Purchasing Power Parity (PPP)
A second example
Reconsider the previous example but now suppose
that the pound appreciated by only 1% in response to
the inflation differential. The increased price of British
goods to US consumers will be apprx 6%<9% (5%
inflation + 1% pound appreciation)
We should expect US consumers to continue shifting
their consumption to British goods. PPP suggests that
this increased US consumption of British goods by US
consumers will persist until the pound appreciated by
4%.
From the US consumers viewpoint, any level of
appreciation lower than this would result in lower
British prices than US prices

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Derivation of Purchasing Power Parity
Relationship between relative inflation rates (I) and
the exchange rate (e).

1 Ih
ef 1
1 I f

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Using PPP to Estimate Exchange Rate Effects
The relative form of PPP can be used to estimate how
an exchange rate will change in response to
differential inflation rates between countries.
International trade is the mechanism by which the
inflation differential affects the exchange rate
according to this theory (Exhibit 8.1)
Using a simplified PPP relationship
e f Ih I f
The percentage change in the exchange rate should be
approximately equal to the difference in inflation rates
between the two countries.

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Example
Assume that the exchange rate is initially in equilibrium.
Then the home currency experiences a 5% inflation rate
while the foreign currency experiences a 3% inflation rate.
According to PPP, the foreign currency will adjust as follows:
1 Ih 1 0.05
ef 1 1 0.0194, or 1.94%
1 I f 1 0.03

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Second Example
Assume that foreign inflation exceeds home inflation. Suppose
that (after the initial equilibrium) the home country
experiences a 4% inflation rate while the foreign country a 7%
rate. According to PPP the foreign currency will adjust

1 Ih 1 0.04
ef 1 1 0.028, or -2.8%
1 I f 1 0.07
The foreign currency should depreciate by 2.8% in response to
the foreign countrys higher inflation relative to that of the home
country. Even though inflation is lower in the home country,
depreciation of the foreign currency puts downward pressure on its
prices from the perspective of home country consumers. When
considering the exchange rate impact, prices of both countries rise
by 4%.

Relationships among inflation and rates


Exhibit 8.1 Summary of PPP

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Graphic Analysis of Purchasing Power Parity
Using PPP theory, we should be able to assess the
potential impact of inflation on exchange rates.
The points on the Exhibit 8.2 suggest that given
an inflation differential between the home and
the foreign country of X percent, the foreign
currency should adjust by X percent due to that
inflation differential.
PPP Line - The diagonal line connecting all these
points together.

Relationships among inflation and rates


Exhibit 8.2 Illustration of PPP

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Graphic Analysis of Purchasing Power
Parity (cont.)
Purchasing Power Disparity
Any points off of the PPP line represent purchasing
power disparity. If the exchange rate does not
move as PPP theory suggests, there is a disparity
in the purchasing power of the two countries.
Point C in Exhibit 8.3 represents a situation where
home inflation (Ih) exceeds foreign inflation (If )
by 4 percent. Yet, the foreign currency
appreciated by only 1 percent in response to this
inflation differential. Consequently, purchasing
power disparity exists.

Relationships among inflation and rates


Exhibit 8.3 Identifying disparity in
purchasing power

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Testing the Purchasing Power Parity Theory
Simple test of PPP (Exhibit 8.4)
Choose two countries (such as the United States and a
foreign country) and compare the differential in their
inflation rates to the percentage change in the foreign
currencys value during several time periods.
Statistical Test of PPP
Apply regression analysis to historical exchange rates
and inflation differentials.
Results of Statistical Tests of PPP
Deviations from PPP are not as pronounced for longer
time periods, but they still exist. Thus, reliance on PPP
to derive a forecast of the exchange rate is subject to
significant error, even when applied to long-term
forecasts.

Relationships among inflation and rates


Exhibit 8.4 Comparison of annual inflation differentials
and exchange rate movements for four major countries

Relationships among inflation and rates


Purchasing Power Parity (PPP)

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Testing the Purchasing Power Parity
Theory (cont.)
Limitation of PPP Tests
Results vary with the base period used. The base
period chosen should reflect an equilibrium position
since subsequent periods are evaluated in
comparison to it. If a base period is used when the
foreign currency was relatively weak for reasons
other than high inflation, most subsequent periods
could show higher appreciation of that currency
than what would be predicted by PPP.

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Why Purchasing Power Parity Does Not Hold
Confounding effects
A change in a countrys spot rate is driven by more than
the inflation differential between two countries:

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Example
Assume that Switzerlands inflation rate is 3% above the
US inflation rate. PPP theory would suggest that the
Swiss franc should depreciate by about 3% against the
US dollar
If the Swiss government imposes trade barriers against
US exports, Switzerlands consumers and firms will not
be able to adjust their spending in reaction to the
inflation differential.
The exchange rate will not adjust as suggested by PPP

Relationships among inflation and rates


Purchasing Power Parity (PPP)
Why Purchasing Power Parity Does Not
Hold
No Substitutes for Traded Goods
If substitute goods are not available domestically,
consumers may not stop buying imported goods.

Relationships among inflation and rates


International Fisher Effect (IFE)
Fisher effect
The International Fisher Effect (IFE) is a
hypothesis in international finance that suggests
differences in nominal interest rates reflect expected
changes in the spot exchange rate between countries
It states that a spot exchange rate is expected to
change equally in the opposite direction of the interest
rate differential
The currency of the country with the higher nominal
interest rate is expected to depreciate against the
currency of the country with the lower rate
IFE has been hypothesized by American economist
Irving Fisher

Relationships among inflation and rates


International Fisher Effect (IFE)
Fisher effect
Suggests that the nominal interest rate contain two
components:
Expected inflation rate
Real interest rate
The real rate of interest represents the return on
the investment to savers after accounting for
expected inflation.

Real rate of interest = Nominal inrerest rate - Expected inflation rate

Relationships among inflation and rates


International Fisher Effect (IFE)

Relationships among inflation and rates


International Fisher Effect (IFE)
Using the IFE to Predict Exchange Rate
Movements
Apply the Fisher Effect to Derive Expected Inflation
per Country
The first step is to derive the expected inflation rates of
the two countries based on the Fisher effect. The Fisher
effect suggests that nominal interest rates of two
countries differ because of the difference in expected
inflation between the two countries. Expected inflation is
higher in the country whose interest rate is higher
Rely on PPP to Estimate the Exchange Rate
Movement
The second step of the international Fisher effect is to
apply the theory of PPP to determine how the exchange
rate would change in response to those expected
inflation rates of the two countries.

Relationships among inflation and rates


International Fisher Effect (IFE)

Relationships among inflation and rates


International Fisher Effect (IFE)

Relationships among inflation and rates


International Fisher Effect (IFE)
Implications of the International Fisher Effect
The international Fisher effect (IFE) theory suggests
that currencies with high interest rates will have high
expected inflation (due to the Fisher effect) and the
relatively high inflation will cause the currencies to
depreciate (due to the PPP effect). The exchange rate
effect could offset the interest rate advantage
Possible investment opportunities are summarized in
Exhibit 8.5. According to the IFE, the expected return
is the same irrespective of where the investors of a
given country invest their funds. Therefore, US
investors who believe in the IFE will not invest in
foreign countries to achieve a higher interest rate
The higher the interest rate in a foreign country, the
higher the expected inflation in that country and the
greater will be the expected level of depreciation in its
currency

Relationships among inflation and rates


Exhibit 8.5 The International Fisher Effect
from various investor perspectives

Relationships among inflation and rates


International Fisher Effect (IFE)
Derivation of the International Fisher
Effect
Relationship between the interest rate (i)
differential between two countries and
expected exchange rate (e)
1 ih
ef 1
1 i f
If ih>if then ef will be positive and the foreign currency will
appreciate. This appreciation will make returns on foreign
securities similar to home security returns
If ih<if then ef will be negative and the foreign currency will
depreciate. This depreciation will make returns on foreign
securities no higher than returns on home securities

Relationships among inflation and rates


International Fisher Effect (IFE)
Derivation of the International Fisher Effect (cont.)
Numerical example based on derivation of the IFE
Assume that the interest rate on a one-year insured home country bank deposit is
11 percent, and the interest rate on a 1-year insured foreign bank deposit is 12
percent. For the actual returns of these two investments to be similar from the
perspective of investors in the home country, the foreign currency would have to
change over the investment horizon by the following percentage:

1 ih
ef 1
1 i f
1 .11
ef 1
1 .12
e f .0089, or - .89%
Summarized in Exhibit 8.6

Relationships among inflation and rates


Exhibit 8.6 Summary of International
Fisher Effect

Relationships among inflation and rates


International Fisher Effect (IFE)
Derivation of the International Fisher Effect
(cont.)
Simplified relationship
The percentage change in the exchange rate
over the investment horizon will equal the interest
rate differential between two countries. This
approximation provides reasonable estimates only
when the interest rate differential is small

e f ih i f

Relationships among inflation and rates


International Fisher Effect (IFE)
Graphic Analysis of the International Fisher
Effect
Point E in Exhibit 8.7 reflects a situation where the foreign
interest rate exceeds the home interest rate by three
percentage points. The foreign currency has depreciated by
3 percent to offset its interest rate advantage.
Point F represents a home interest rate 2 percent above the
foreign interest rate. IFE theory suggests that the currency
should appreciate by 2 percent to offset the interest rate
disadvantage.
Point F illustrates the IFE from a foreign investors
perspective. The home interest rate will appear attractive to
the foreign investor. However, IFE theory suggests that the
foreign currency will appreciate by 2 percent.

Relationships among inflation and rates


Exhibit 8.7 Illustration of IFE line (when exchange rate
changes perfectly offset interest rate differentials)

Relationships among inflation and rates


International Fisher Effect (IFE)
Graphic Analysis of the International Fisher
Effect (cont.)
Points on the IFE Line
All the points along the IFE line reflect exchange rate
adjustments to offset the differential in interest rates.
This means investors will end up achieving the same
yield (adjusted for exchange rate fluctuations) whether
they invest at home or in a foreign country.
Points below the IFE Line
Points below the IFE line generally reflect the higher
returns from investing in foreign deposits.
Points above the IFE Line
Points above the IFE line generally reflect returns from
foreign deposits that are lower than the returns possible
domestically.

Relationships among inflation and rates


Tests of the International Fisher Effect
What Can be Tested (Exhibit 8.7)
If the actual points (one for each period) of interest
rates and exchange rate changes were plotted over
time on a graph, we could determine whether
the points are systematically below the IFE line
(suggesting higher returns from foreign investing),
above the line (suggesting lower returns from foreign
investing), or
evenly scattered on both sides (suggesting a balance of
higher returns from foreign investing in some periods
and lower foreign returns in other periods).
Statistical Test of the IFE
Apply regression analysis to historical exchange rates
and the nominal interest rate differential.

Relationships among inflation and rates


Exhibit 8.8 Illustration of IFE concept (exchange rate
changes offsetting interest rate differentials on average)

Relationships among inflation and rates


Tests of the International Fisher Effect
Limitations of the IFE
The IFE theory relies on the Fisher effect and PPP
Limitation of the Fisher Effect
The difference between the nominal interest rate and
actual inflation rate is not consistent. Thus, while the
Fisher effect can effectively use nominal interest rates to
estimate the markets expected inflation over a particular
period, the market may be wrong.
Limitation of PPP
Other country characteristics besides inflation (income
levels, government controls) can affect exchange rate
movements. Even if the expected inflation derived from
the Fisher effect properly reflects the actual inflation rate
over the period, relying solely on inflation to forecast the
future exchange rate is subject to error.

Relationships among inflation and rates


Tests of the International Fisher Effect
IFE Theory versus Reality
The IFE theory contradicts how a country with a high
interest rate can attract more capital flows and
therefore cause the local currencys value to
strengthen (Ch. 4).
IFE theory also contradicts how central banks may
purposely try to raise interest rates in order to
attract funds and strengthen the value of their local
currencies (Ch. 6).
Whether the IFE holds in reality is dependent on the
countries involved and the period assessed.
The IFE theory may be especially meaningful to
situations in which the MNCs and large investors
consider investing in countries where the prevailing
interest rates are very high (mainly less developed
countries with higher inflation their currencies will
depreciate which could offset any interest rate
advantage and might even result in losses)

Relationships among inflation and rates


Comparison of the IRP, PPP, and IFE
Although all three theories relate to the
determination of exchange rates, they have
different implications. (Exhibit 8.9)
IRP focuses on why the forward rate differs from the
spot rate and on the degree of difference that should
exist. It relates to a specific point in time.
PPP and IFE focus on how a currencys spot rate will
change over time.
Whereas PPP suggests that the spot rate will change
in accordance with inflation differentials, IFE
suggests that it will change in accordance with
interest rate differentials.
PPP is related to IFE because expected inflation
differentials influence the nominal interest rate
differentials between two countries.

Relationships among inflation and rates


Exhibit 8.9 Comparison of the IRP, PPP,
and IFE theories

Relationships among inflation and rates


Summary
Purchasing power parity (PPP) theory specifies a
precise relationship between the relative inflation
rates of two countries and their exchange rate.
PPP theory suggests that the equilibrium
exchange rate will adjust by about the same
magnitude as the difference between the two
countries inflation rates. Although PPP continues
to be a valuable concept, there is evidence of
sizable real-world deviations from the theory.

Relationships among inflation and rates


Summary
The international Fisher effect (IFE) specifies a precise
relationship between relative interest rates of two countries
and their exchange rates. It suggests that an investor who
periodically invests in interest-bearing foreign securities
will, on average, achieve a return similar to what is possible
domestically. This implies that the exchange rate of the
country with high interest rates will depreciate to offset the
interest rate advantage achieved by foreign investments.
Yet there is evidence that the IFE does not hold during all
periods, which means that investment in foreign short-term
securities may achieve a higher return than what is possible
domestically. However, a firm that attempts to achieve this
higher return also incurs the risk that the currency
denominating the foreign security depreciates against the
investors home currency during the investment period. In
that case, the foreign security could generate a lower
return than a domestic security even though it exhibits a
higher interest rate.

Relationships among inflation and rates


Summary
The PPP theory focuses on the relationship
between the inflation rate differential and future
exchange rate movements. The IFE focuses on
the interest rate differential and future exchange
rate movements. These theories explain how
exchange rates move over time, while interest
rate parity (IRP) theory covered in the previous
chapter focuses on the relationship between the
interest rate differential and the forward rate
premium (or discount) at a given point in time.

Relationships among inflation and rates


Thank you for your attention

Relationships among inflation and rates